How does the banking system create money? Explain with examples
The correct answer and explanation is :
The banking system creates money primarily through a process called fractional reserve banking. In this system, banks only need to keep a fraction of deposits as reserves and can lend out the remainder. This lending creates money in the form of new deposits in the economy. Here’s how it works:
Example:
- Initial Deposit: Suppose you deposit $1,000 into your bank account. This is the initial deposit.
- Reserve Requirement: Banks are required to keep a certain percentage of deposits as reserves. If the reserve requirement is 10%, the bank must keep $100 in reserves and can lend out $900.
- Lending: The bank then lends $900 to someone else, say a borrower who buys goods or services. When the borrower spends that $900, it is deposited into another bank, creating new deposits.
- New Deposit: The $900 deposited into the second bank also becomes part of the money supply, and the second bank is required to keep only 10% of this amount in reserve ($90), lending out the remaining $810.
- Money Multiplier: This process repeats, with each subsequent loan leading to new deposits, thus creating more money. The total amount of money created in the economy can be much larger than the original deposit. The money multiplier can be calculated as ( \frac{1}{\text{reserve requirement}} ). In this case, if the reserve requirement is 10%, the multiplier is ( \frac{1}{0.10} = 10 ), so the initial $1,000 deposit can ultimately lead to $10,000 in new money.
Impact on the Economy:
This process allows the banking system to increase the money supply beyond the actual physical currency in circulation. When banks lend out money, it circulates in the economy, stimulating investment and consumption. However, if banks lend too much, it can lead to inflation, whereas if they restrict lending, it can slow down economic activity.
In essence, banks don’t just lend out physical cash; they create new money by extending credit, thereby expanding the money supply.