Stepwise Process of Money Creation by Commercial Banks with Example
Money creation by banking system is a core concept in economics which explains how banks do not just lend the money they receive in deposits, but can increase the total money supply in the economy through a cycle of lending and deposit creation. This topic is crucial for school exams, competitive banking tests, and understanding how everyday banking impacts economic growth.
| Step | Action | Result |
|---|---|---|
| 1 | Customer deposits cash in a commercial bank | Bank holds a share as reserve, remaining available for lending |
| 2 | Bank lends a part of deposits to new borrowers | Borrowed amount is spent and redeposited into the banking system |
| 3 | Other banks receive redeposited funds | Further lending and deposit creation occur |
| 4 | Process repeats with each new round | Overall money supply multiplies beyond the initial deposit |
Money Creation by Banking System: Definition and Process
Money creation by banking system refers to the process where commercial banks increase the money supply beyond the cash deposited. This is possible due to fractional reserve banking, where banks keep only a percentage of deposits as reserves and lend out the rest, creating new deposits and expanding the total money in the economy.
Fractional Reserve Banking and Money Multiplier
Commercial banks use fractional reserve banking, meaning they are legally required to keep only a fraction (for example, 10%) of deposits as reserves. The rest is lent out. The cycle of lending and redepositing creates a 'money multiplier' effect, allowing the total money supply to grow multiple times the original deposit.
Example of Money Creation
Suppose a person deposits ₹1,000 in Bank A. If the reserve ratio is 10%, Bank A keeps ₹100 as reserve and lends ₹900. If the borrower spends ₹900 and the recipient deposits it in Bank B, Bank B keeps ₹90 (10%) and lends ₹810. This continues, leading to the creation of more money at each step. The total money created can be calculated using the formula:
Total Money Created = Initial Deposit × (1 / Reserve Ratio)
In the above case, total money created = ₹1,000 × (1/0.10) = ₹10,000.
Factors Affecting Money Creation
Several factors influence how much money the banking system can create:
- The central bank sets the required reserve ratio.
- Public preference for holding cash outside banks reduces the process.
- Willingness of banks to lend and of borrowers to take loans.
- Government and central bank policies affect credit flow and interest rates.
Money Creation by Commercial Banks vs Central Bank
| Aspect | Commercial Bank | Central Bank |
|---|---|---|
| How Money is Created | Lending and deposit cycle (credit creation) | Issuing currency notes, managing reserves |
| Control | Limited by regulations and reserves | Complete authority on printing and overall supply |
| Function | Creates 'credit money' | Creates 'base money' or 'high-powered money' |
Why Is Money Creation Important for Students?
Understanding money creation by banking system helps in Class 12 board exams, competitive exams like UPSC, and enhances real-life banking awareness. It explains how your bank deposits multiply within the economy, impacting inflation and growth. At Vedantu, we simplify such key Commerce topics for easy revision.
Uses of Money Creation Concept
- Helps policymakers and economists manage money supply and inflation.
- Essential for evaluating money and banking policies.
- Guides business people in understanding loan and deposit cycles.
- Important in macroeconomics for exam and practical applications.
Key Terms in Money Creation by Banking System
| Term | Meaning | Related Topic |
|---|---|---|
| Reserve Ratio | Fraction of deposits banks must keep as reserves | Reserve Bank of India |
| Money Multiplier | Extent to which deposit money can be multiplied | Money Multiplier |
| Credit Creation | Banks lending from deposits to create new money | Functions of Commercial Banks |
| High-powered Money | Base currency issued by central bank | Central Bank |
Real-life Example of Money Creation
When you deposit ₹10,000 in your bank, the bank sets aside ₹1,000 (if reserve ratio is 10%) and lends out ₹9,000. That ₹9,000 may be spent and again comes back into the system as new deposits, and banks continue this process, multiplying the overall money in circulation. This cycle supports lending for homes, businesses, and daily purchases.
Links for Further Study
- Money and Banking
- Functions of Commercial Banks
- Reserve Bank of India
- Supply of Money
- Money Multiplier
In summary, money creation by banking system explains how banks multiply the money supply by lending and redepositing, using the fractional reserve system. This process is key for economic activity and is often questioned in Commerce exams and interviews. At Vedantu, our lessons make this and other complicated Commerce topics easy to understand for every learner.
FAQs on Money Creation by Banking System Explained
1. How does the banking system create money?
Commercial banks create money through fractional reserve banking. They lend out a portion of deposits, creating new money in the process. This is because the money lent out is deposited again, allowing for further lending and money creation, amplified by the money multiplier.
2. What is meant by fractional reserve banking?
Fractional reserve banking is a system where banks are required to hold only a fraction of their deposits as reserves (the reserve ratio), while lending out the rest. This fraction allows for the creation of new money through lending and subsequent deposit cycles.
3. How does the reserve ratio affect money creation?
The reserve ratio directly impacts money creation. A lower reserve ratio allows banks to lend out a larger portion of deposits, leading to greater money creation. Conversely, a higher reserve ratio restricts lending and limits the expansion of the money supply.
4. What is the difference between money creation by commercial banks and the central bank?
Commercial banks create money through lending and deposit multiplication, based on the fractional reserve system. The central bank, like the Reserve Bank of India (RBI), controls the overall money supply through monetary policy tools such as changing reserve requirements, interest rates, and open market operations. It doesn't directly create money in the same way commercial banks do.
5. Can the process of money creation decrease? Under what conditions?
Yes, money creation can decrease. This happens when:
• The reserve ratio is increased by the central bank
• There is reduced demand for credit from borrowers
• The public increases their cash holdings (reducing deposits)
• Banks become more cautious about lending due to economic uncertainty.
6. How is money created by the banking system?
Banks create money through a process called credit creation or deposit multiplication. It begins when a deposit is made. The bank keeps a fraction as reserves and lends the rest. This loan becomes a deposit in another bank, repeating the cycle, thus expanding the money supply. The money multiplier formula helps calculate the total money created.
7. How does the bank make money?
Banks primarily earn money through interest on loans they provide to customers and businesses. Other sources include fees charged for services (e.g., transaction fees) and investments made.
8. What is money in the banking system?
In the banking system, money refers to both physical currency and demand deposits (easily accessible funds in bank accounts). Demand deposits are considered money because they are readily usable for transactions.
9. What practices of the banking system can lead to the creation of money?
The primary practice leading to money creation is fractional reserve lending. By lending out a portion of deposits, banks create new money, as these loans become deposits elsewhere, continuing the cycle. The reserve ratio and the public's demand for credit are also significant factors.
10. Why can't banks lend an unlimited amount despite the money creation process?
Banks can't lend unlimited amounts because of several factors including:
• **Reserve requirements:** Banks must maintain a minimum reserve ratio set by the central bank.
• **Credit risk:** Banks assess the creditworthiness of borrowers before lending, limiting lending based on risk.
• **Demand for loans:** The demand for loans influences how much money banks can lend.
• **Economic conditions:** During economic downturns, banks tend to reduce lending to manage risks.
11. How do open market operations by RBI impact the ability of banks to create money?
The Reserve Bank of India's (RBI) open market operations (OMO) affect banks' money creation capacity. When RBI buys government securities, it injects money into the banking system, increasing the money supply and banks' capacity to lend. Conversely, selling securities reduces the money supply, restricting lending and money creation.
12. Could excessive money creation by banks lead to inflation? How?
Excessive money creation can lead to inflation. When there's significantly more money circulating in the economy than goods and services, the value of money decreases, causing prices to rise. This is because increased money supply pushes up demand without a corresponding increase in supply.
