Question

explain money creation，one by a depository and the other by the federal reserve

Answer 1

Commercial banks are the creators of money supply in the economy. They contribute to the money supply by creating credit. They create credit in the form of demand deposits. Demand deposits of the commercial banks are many times more than cash reserves. If cash reserves are $ 1000 and if demand deposits say $ 10,000, then commercial banks are creating credit ten times of their cash reserves. Accordingly, on the basis of cash reserves of $ 1000, the commercial banks are contributing $ 10,000 to the supply of money. The steps involved in the creation of money are as follows:

1) Commercial banks know by their historical experience that, all the depositors would not show up in the banks to withdraw all their deposits at a point of time.

2) Commercial banks will maintain a reserve of 10% if they experience withdrawals are generally around 10% of total deposits. This is known as CRR i.e. Cash Reserve ratio.

3) If CRR = 10%, total cash reserves will be $ 1000 which allow the bank to loan up to $ 10,000 in accordance with the given formula:

Demand deposits = 1/CRR X Cash reserves = 1/10% X 1000 = $ 10,000

It is important to note that Loans are never offered in cash. These are always reflected as demand deposits in favor of the borrowers.

4) Now we can say that if cash reserves of the bank increased by 1000 then credit supply increases by $ 10,000 on the assumption that CRR = 10%.

Example:

If a person M deposits $ 1000 with the bank and CRR = 10%. How will this affect the balance sheet?

When the bank receives $ 1000 then it showed as demand deposit = 1000 on the liability side of the balance sheet and $ 1000 as cash on the asset side of the balance sheet.

Required reserve ratio = 10% i.e. 10% of $ 1000 is saved by the bank

Reserves = $ 100

Bank will now provide loan of $ 1000 - 100 = $ 900

Since loan is not provided in the form of cash so this loan amount of $ 900 is further deposited in the bank. This will further be recorded as deposits of 900 and cash of 900 and this process continues.