Question

How does the banking system create money? Explain by giving an example. (150words)

please do not write HANDWRITING because I dont understand your WANDWRITING STYLE

Answer 1

Banking System is the crust of any economy. Whether economy achieves various heights or falls, its major player is banking system. We know that Banks make profit by lending the amount as loans which they receive as deposits. This difference between interest rate of lending and interest rate on savings helps banks to make profits and carry their operational costs.

Now, the question arises, how do they make money. Whenever we deposit money we get the amount deposited in digital form that flashes on our phone screens, ATMs or passbooks. People invest with the intension of not using this money immediately and use the invested amount along with interest after some time. This very behaviour encourages banks to use this invested amount to invest further in form of providing loans to individuals, government, companies, start ups etc. Similarly, the borrower also receives the loan amount in digital format. Thus, banks multiply the money by reinvesting it. This enables them to create money not in the actual form but digital one.

This multiplies the amount which was brought out of the economy as savings and re entered in the economy as investments to multiple borrowers. Now this brings one more term in consideration known as money multiplier. This means that up to which extent can banks create money with the given pool of deposits. It is given by reciprocal of reserve ratio. Thus, higher the reserve ratio lower is the creation of money and vice versa. Let’s study this creation of money with the help of an example.

Example

Suppose that, there is a Bank Manager, named John. He has been instructed by Central Bank to reserve 10% of the deposits to finance any immediate withdrawal by depositors. The total Sum of deposits is $5,000,000.

Now, John is supposed to keep the reserves i.e. 10% of $5,000,000. Subtracting the reserves, we get $4,500,000 ($5,000,000 - $ 500,000). In order to maximise the profits, John will instruct to lend these $4,500,000. Thus, without even creation of money by central bank money supply gets increased from $ 5,000,000 to $9,500,000. This is how money in created by banks.