Question

a) Explain how banks create money using T-accounts? b) Explain in detail the concept and working of money multiplier

Answer 1

Answer a) T- accounts are a tool for describing the financial position of a business by showing assets and liabilities in a table. Each side of the table must equal the other side in T-account. The assets are on left side and liabilities are on the right side.

Let us assume that bank X has been opened. Now as it’s a new bank nobody has deposited any money in it. So apart from the obligations to the bank owners and the real assets that the bank has its T-account will be empty.

Suppose if a person wins a lottery of $100 and deposits it to the bank X. Now these $100 will become under the asset side. Also, it's important to note that the bank has the obligation to give this money to the person. Therefore these $100 will come on the liability side also.

Answer b)

The Money Multiplier is defined as how an initial deposit in a bank can lead to a bigger final increase in the total money supply. Let us take an example: If a bank has gained deposits of $1 million and this has lead to a final money supply of $10 million. Therefore, the money multiplier will be 10 in this case.

For example, if the commercial banks gain deposits of £1 million and this leads to a final money supply of £10 million. The money multiplier is 10.

The money multiplier plays a key role in the banking system:

1. Initially, there will be an increase in bank deposits which is known as the monetary base.

2. Bank keeps a fraction amount of it and deposits rest either in reserves or lends out the rest

3. The bank loan will further re-deposited in banks which allows further increase in the lending and further increases the money supply.

Here it is important to note the reserve ratio

The Reserve Ratio: It is the % of deposits that banks keep in liquid reserves. A bank can keep 10% or 20%. This totally depends on the policy of the bank.

The formula for money multiplier: 1/ Reserve ratio

For example if reserve ratio is 5%. The money multiplier will be 1/0.05= 20