Question

Money is created when someone \((\mathrm{LO4})\) a) takes out a bank loan b) pays back a bank loan c) spends money d) saves moncy

Short answer

In conclusion, money is created when someone takes out a bank loan (option a). This is because banks lend money that is not fully backed by their cash reserves, effectively increasing the overall money supply. Other options, such as paying back a bank loan, spending money, or saving money, do not directly lead to the creation of new money in the economy.

Step-by-step solution

Understand the process of money creation

To determine when money is created, it is important to understand how the process of money creation works. Money is created in the banking system by leveraging deposits and expanding credit, which means that banks lend money that is not necessarily backed by an equivalent amount of actual cash reserves. Now, let's analyze each option and see which corresponds to the process of money creation:

Option a: Takes out a bank loan

When someone takes out a bank loan, the bank lends them money that is not fully backed by their cash reserves. This additional money is created as a result of the fractional reserve banking system, which allows the financial institution to "create" money through their lending operations. So, when someone takes out a bank loan, they increase the overall money supply. Therefore, this option represents the process of money creation.

Option b: Pays back a bank loan

When an individual pays back a bank loan, the process of money destruction takes place. Money that was created during the issuance of the loan is effectively removed from the financial system, as the repayment of the loan reduces the bank's outstanding credit and reduces the overall money supply. So, this option does not correspond to the process of money creation.

Option c: Spends money

When money is spent by an individual, the money basically changes hands within the economy. However, the overall money supply remains the same. Spending money does not create new money in the financial system; it merely causes money to circulate from one economic agent to another. Hence, this option does not represent the process of money creation.

Option d: Saves money

Saving money involves setting aside a portion of an individual's income instead of spending it. While saving enables banks to have more cash reserves, thereby potentially affecting the amount of money they can lend, the act of saving itself does not create new money in the economy. Hence, this option does not correspond to the process of money creation. #Conclusion#: Based on the analysis of the given options, we can conclude that money is created when someone takes out a bank loan, i.e., option a).

Key concepts

Fractional Reserve Banking

Fractional reserve banking is the cornerstone of modern banking systems and plays a vital role in the creation of money. Under this system, banks are only required to keep a fraction of their deposits as reserves. The remaining portion can be used to issue loans and credit to other customers. This process amplifies the ability of banks to create money because the same funds that are deposited can be lent out multiple times, only limited by the reserve requirement set by the bank's regulatory authority.

For example, if the reserve requirement is 10%, a bank can lend out 90% of its deposits. When the bank lends this money to a borrower, the borrowed funds deposit into the economy increases the total amount of money in circulation. Subsequently, when these funds are deposited by the borrower into their bank account, the process repeats, allowing further expansion of credit and creation of money – a concept known as the money multiplier effect.

Bank Loans

Bank loans are not only a significant service provided by financial institutions but also a fundamental process in money creation. When a bank issues a loan, it does not hand out existing money but effectively generates new money. The reality that may surprise many is that the money lent out by the bank does not necessarily come from the money deposited by other customers; instead, it is created out of thin air, based on the fractional reserve principle.

This creation of money happens at the moment the loan is disbursed, creating new bank deposits, which count as part of the money supply. It's worth noting that these newly created funds increase purchasing power and stimulate economic activity. However, when a loan is paid back, the reverse happens. The money used to repay the loan 'disappears' from the economy, thus decreasing the money supply.

Money Supply

The term 'money supply' refers to the total amount of money available within an economy at any given time. This includes both physical money, like coins and banknotes, and digital money in the form of bank deposits. The central bank of a country can influence this supply by setting reserve requirements for banks and using monetary policy tools such as open market operations and interest rate adjustments.

The process of bank lending, related to fractional reserve banking, directly impacts the money supply in an economy. Moreover, when loans are taken out, as highlighted in the exercise, the money supply expands. Conversely, when loans are paid off, the money supply contracts. Thus, money supply is dynamic and can change frequently as a result of banking activity, central bank policies, and the behaviors of economic agents like savers and spenders. It's essential for students to understand that the health and stability of an economy are closely related to the proper management of the money supply.