Question

Concisely describe the role banks play in the money creation process given a fractional reserve system.

Answer 1

The central bank of a country has the prime responsibility of issuing currency on behalf of the government. It regulates the money supply in an economy by framing suitable monetary policies. Central banks give money on loan to commercial banks and in the process new money is created by commercial banks. Under a fractional reserve system of banking, commercial banks are required to keep only a fraction of their deposits in reserves and lend the rest. The reserves must be at least equal to a fraction of the bank's deposit liabilities. This system allows banks to create credit and increase their liquidity.

The commercial banks lend money to other banks which too re loan the amount remaining after setting aside the reserve requirements. Thus, the process of lending creates money at different stages and the money supply is increased within an economy. For instance, a deposit of $ 2000 will not be lend out entirely by the bank nor will it be retained entirely by the bank ; the bank will be required to keep 10% (usual rate) of the amount as reserves and lend out the rest. In the given example, the bank will hold $200 in reserve and offer the remaining $1800 for loans. The central bank regulates the financial system and implements its policies through the fractional reserve system. Increasing the reserve decreases money supply and decreasing it increases money supply in an economy.

(Reference: investopedia.com and Wikipedia )