Question

How do banks create money? Explain with an example

How does a $1,000 withdrawn from Pat’s account affect the monetary base? Explain

The Fed buys $300 million of bonds from the public. How will this affect the Fed’s balance sheet? Explain

Answer 1

a. Banks create money by lending out their excess reserves money. When people deposit money in banks, banks keep some portion of the deposits as required reserves which is mandated by the Central Bank and use the residual amount = Total Deposits - Required Reserves or Excess reserves for lending purposes and by lending these funds, people borrow money and this is used for investment purposes. For example, if total deposits are Rs1000 and required reserve ratio is equal to 10 per ent, then required reseverves is equal to Rs.100 and Rs.1000 - rs.100 = rs.900 can be used for lending purposes by banks. The total money created is given by money multiplier = 1 / Required reserve ratio.

b. The amount withdrwan from banks reduces the reserves of banks or total deposits of banks and this reduction in total deposits lead to decline in the monetray base of banks.

c. This will increase assets of the Fed's balance sheet because it has purchased assets from the public. It will also lead to increase in money supply in the economy.