Question

a) Explain how one bank creates money

b) how does the banking system creates money?

c) Define the money multiplier and explain why the multipler is likely to overstate the actual Increase in the money supply

Answer 1

a) Suppose a bank has, hypothetically, $10 million as deposits. This bank is required to have 10% of the total deposits as reserves to cover withdrawals. The reserve amount is equal to $1 million. The bank is allowed to lend the remaining $9 million to anyone who needs it. The loan of $9 million will fetch the bank interest payments. This is the how the bank will create money beyond the $10 million it initially had.

b) Now suppose, the business to which this $9 million was loaned out to deposits this sum to another bank, say Bank 2. 10% of this sum is kept as reserves in Bank 2. It leaves Bank 2 with $8.1 million to lend. This sum of money when loaned out then generates interest income for Bank 2.

This chain goes on, with Bank 2 lending to Bank 3. Bank 3 keeping 10% reserve and lending out the rest to Bank 4, which in turn keeps 10% deposit and so on.....

This is how money is created in the banking system.

c) As we saw, with each successive bank keeping a reserve amount and lending the rest, the money supply is expanding. The amount of money that the system can create is found by using the money multiplier. The money multiplier tells us by how many times a loan will be “multiplied” through the process of lending out excess reserves, which are deposited in banks as demand deposits. Thus, the money multiplier is the ratio of the change in money supply to the initial change in bank reserves.

Money multiplier is = 1/Required Reserve Ratio

The required reserve ratio is 10%, then the money multiplier is = 1/0.1 = 10, i.e. the money supply will increase by 10 times!

This increase in the money supply is actually over-estimated by the multiplier because the multiplier formula does not take into account the excess reserves that banks keep. Excess reserves are capital reserves held by a bank or financial institution in excess of what is required by regulators, creditors or internal controls. Also, the central bank does not really have, in real life, full control on the monetary base.