Question

Discuss role play by Bank in the monetary system? How do bank create money?

[10 Marks]

Answer 1

Banks works as financial intermediaries through which they accepts payment from public, give loans to public. It works as an intermediary between saver and borrower in the economy through which borrowers can get the money while paying the defined rate of interest which banks provide to savers for depositing that money in their bank while keeping their own percentage profit. They take from rate of interest from borrowers while give less to savers.

Assume the reserved required ratio is 10% which means that if bank have $1,000 with them they can lend out 90% of them while keeping 10% with them. They loan out $900 to the public. We assume that the lent out money is again deposited in the bank for transactional purposes which banks loan out again while keeping 10% of it. Thus banks again lent out $810 to the public which again is deposited into the bank and this flow goes on. The maximum amount a bank can generate is calculated as $1,000 * (1 / r) where r is reserve ratio. With initial $1,000 and 10% reserve ratio, banks can generate 1000 / 0.10 = $10,000.