Money Creation By Banking System

Introduction

A piece of common knowledge for laymen is that banks deposit and lend money are loans. But, people hardly know that banks create money when they extend a loan. Banks usually deposit a portion of the deposited money and offer a major portion of its reserve as loans.

When such a process is followed, the bank necessarily creates an account in the name of the loan bearer. When such an account is created and money is deposited in that account, fresh capital is created by the banks. To understand the process of such money creation, let’s look at the process of a bank’s operation closely.

Bank Loans and The Money Multiplier

There is an alternative way of working with a money multiplier that creates new money in the banking system. To understand that, the idea of 100% reserved Banking and fractional banking is necessary.

Hundred Percent Reserve Banking

In a world that does not have any bank, the currency would be held by people is the total amount of money in the system. As there would be no bank, whatever currency is in the hands of the people, that is the total amount of money in the economy. Now, let’s consider a bank is established that has a deposit service but it does not lend any money as loans. That is let’s suppose that the bank accepts deposits from the public and keeps the money safe but does not lend any loan to the public.

The deposits made by the public in the bank is known as reserve. Therefore, in the given system some of the money is stored as a reserve in banks’ vaults but the majority of the reserve is stored in a central bank, such as the Reserve Bank of India. So, in our example, 100 percent of the money is in reserve because the money has not been used by the banks.

In such a system, the money stays with the bank until someone withdraws money physically or by writing a cheque against the balance. This process of banking is called 100 Percent Reserve Banking. In this system, the banks make a profit from the commissions it charges for their services but it does not earn profits from their deposits because it does not earn profits from their assets.

Example, suppose the Bank established is known as Bank X. If the public deposit the economy’s entire Rs 1,000 in the bank, the assets, and liabilities of the bank will both be Rs 1,000. One rupee deposited in the bank will reduce the currency by Re 1 while it will increase the deposits by Re 1. So, the money supply does not change at all. If the banks hold entire money in the economy as reserves, it is called 100 percent reserve banking. So, 100 percent reserve banking cannot create credit or new money.

Fractional Reserve Banking

In general, the returns or the interest paid to deposits in the bank is lower than the interest applied to the loans. Therefore, the banks earn a profit by extending loans to the public.

• The banks create deposits in the process of making loans and the loan is usually credited to the borrower’s account. Thus, the process of making profitable loans increases the chances of increasing the deposits.

• The banks usually do not use the entire deposit in hand when the demand for loans is low. The entire amount of reserve is not used by banks and a palpable amount of reserve is held by the banks when the demand for loans is low. However, when the demand for loans is high, banks may borrow the reserves at the discount window. This is usually done to create additional deposits that accompany the increase in loans. The flexibility enjoyed by banks in using money supply and borrowing capital when needed makes the money supply responsive to the interest rate and loan demand.

• When the demand for loans is strong, the banks will tend to borrow more money at the discount window, making it more prral banks have liabilities that include demand deposits and assets, such as loans and reserves. The central bank requires the banks to keep a certain portion of their liabilities as reserves.

• The banks must keep some money to meet the demand for withdrawal fulfilled. However, when the demand for withdrawals is equal to the deposits, banks do not need to keep a significant portion of their money as reserves. So, they can lend money that is not used as loans to the non-bank public. This means that the banks can use a fraction of their reserves as loan incentives. When such a system is followed by banks, it is known as a fractional reserve system.

Here’s how the X Bank’s balance sheet will look in the cases of 100% Reserve System and Fractional Reserve Systems.

Table 1: 100% Reserve System

Assets	Liabilities
Reserves Rs 1,000	Deposits Rs 1,000

Table 2: Fractional Reserve System

Assets	Liabilities
Reserves Rs 100	Deposits Rs 1,000
Loans Rs 900

In the case of the fractional reserve system, the reserve-deposit ratio is 10%. So, out of the total Rs 1000 of the deposits, Bank X keeps Rs 100 as reserves and lends the remaining Rs 900 as loans. It can be observed that the bank has created Rs 900 of new money by supplying Rs 900 as a loan in the system.

When the loan was not made, the total money supply is Rs 1,000 which is equal to the deposit in Bank X. After the loan was made, the total money supply is Rs 1,900 where the depositor still has a demand deposit of Rs 1,000 but the borrower holds Rs 900 too.

The money creation does not stop here. With successive deposits of the loan in other banks, the money creation process goes on repeatedly.

Conclusion

The money creation process of banks is an important subject in economics because it is central to the medium of exchange, money. Knowing how money is created therefore offers an insight into the process of money creation which must be learned by one and all.

FAQs

Qns 1. How many types of banking systems are there?

Ans. There are two types of banking systems - 100 percent reserve banking and fractional reserve banking system.

Qns 2. Does any loan is offered to the public in a 100 percent reserve banking system?

Ans. No. In 100 percent reserve banking, banks just keep the deposited money of the public safe.

Qns 3. Which system of banking is the common process in the economy?

Ans. Fractional reserve banking is the common banking process in the economy.