Question

How do banks create money?

Short answer

Banks create money through the fractional reserve banking system and the money multiplier effect. In fractional reserve banking, banks hold only a fraction of their customers' deposits as reserves and lend out the rest. This leads to the expansion of credit and an increase in the money supply. The money multiplier effect occurs as the lent-out money is deposited in other banks and further lent out in multiple rounds, multiplying the initial deposit amount. Central banks control this money creation process by adjusting the reserve requirement, which influences the overall functioning of an economy.

Step-by-step solution

1. Understanding the basic concept of banks and money creation

Banks are financial institutions that accept deposits from customers and then use those deposits to extend loans and provide other financial services. A key aspect of this process is the concept of fractional reserve banking, which allows banks to create new money by lending out a portion of customer deposits. This money creation happens through the expansion of credit and the increase in the money supply.

2. Fractional reserve banking

Fractional reserve banking is a banking system in which banks are required to hold only a fraction of their customers' deposits as a reserve, while they can lend out the remaining amount. The reserve ratio determines the percentage of deposits that banks must keep in reserve. For example, if the reserve ratio is 10%, a bank must hold \(10 as reserve for every \)100 of deposits it takes in. The bank can then lend out the remaining $90.

3. Money multiplier effect

The money multiplier effect is a process through which banks create money by lending out a large portion of their deposits, leading to the expansion of the money supply. When a bank lends out money, it increases the amount of credit available in the economy. This borrowed money is then deposited at another bank, which can further lend out a portion of the deposit, creating more credit. This process continues through multiple rounds, leading to a multiplication of the initial deposit amount and an increase in the overall money supply of the economy.

4. The Reserve Requirement

To control the money creation process, banks are often subject to a reserve requirement imposed by a central bank. The reserve requirement is the percentage of total deposits that a bank must hold as reserves, which limits the amount of money the bank can lend out. By adjusting the reserve requirement, central banks can influence the money supply and consequently, control inflation or deflation in an economy.

5. The money creation process in action

Let's consider a simple example to illustrate the process of money creation by banks. Assume that a person deposits \(1000 into Bank A, and the reserve requirement is 10%. Bank A holds \)100 as a reserve and lends out \(900 to another person. That person then deposits the \)900 into Bank B. Bank B holds \(90 as a reserve and lends out \)810 to another person. This process continues, leading to an overall increase in deposits and loans throughout the banking system, and thus increasing the total money supply within the economy. In conclusion, banks create money through the fractional reserve banking system and the money multiplier effect. By taking in deposits and lending out a portion of those deposits, banks facilitate the expansion of credit, leading to an increase in the money supply. Central banks can control the extent of money creation by adjusting the reserve requirement, which influences the overall functioning of an economy.