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Chapter 5: Problem 19
How do banks create money?
Short Answer
Expert verified
Banks create money through the process of fractional reserve banking, where they are required to hold a certain amount of cash reserves, determined by the reserve requirement set by the Central Bank, and can lend out the rest of their deposits. The money multiplier, calculated as \(\frac{1}{Reserve Requirement}\), shows the maximum amount of new money that can be created for every unit of reserves in the banking system. By issuing loans and receiving deposits, banks increase the overall money supply, while the Central Bank regulates this process to maintain economic stability.
Step by step solution
01
1. Understand the role and functions of a Central Bank
A Central Bank is an institution that oversees a country's monetary policy and financial system in order to maintain the stability of the national currency, manage interest rates, and ensure a stable money supply. It also acts as a lender of last resort to commercial banks during times of financial crisis. The Central Bank controls the money supply by setting the reserve requirement, interest rates, and conducting open market operations.
02
2. Learn about Commercial Banks and their functions
Commercial Banks are financial institutions that accept deposits from individuals and businesses, provide loans, and offer investment products and services. They make profits by charging interest on the loans, which is higher than the interest they pay on deposits. A key point to understand is that commercial banks do not only lend out the money they have as deposits but can also create additional money by extending loans in excess of their reserves, which is known as fractional reserve banking.
03
3. Understand the concept of Fractional Reserve Banking
Fractional Reserve Banking is a banking system in which banks are required to hold a certain amount of cash reserves, determined by the reserve requirement set by the Central Bank, and can lend out the rest of their deposits. This means that banks create new money as loans, which are then deposited back into the banking system, increasing the money supply. The money multiplier effect shows how this process can cause a significant increase in the money supply.
04
4. Examine the concept of the Money Multiplier
The Money Multiplier is a formula that shows the maximum amount of new money that can be created for every unit of reserves in the banking system. It is calculated using the formula: \[Money Multiplier = \frac{1}{Reserve Requirement}\]The higher the reserve requirement, the lower the money multiplier, meaning less money can be created through fractional reserve banking. Conversely, a lower reserve requirement allows banks to create more money through lending.
05
5. Apply the concepts to the money creation process
When an individual or business takes out a loan from a commercial bank, the bank creates new money by issuing the loan, without necessarily using any existing deposits. The borrower then uses the loan to make payments, and the payees deposit the money in their bank accounts. Since this new deposit increases the available reserves of other banks, they can also loan out a portion of it, creating even more money. This process continues until the entire amount created has been loaned out and redeposited multiple times. The total money supply is determined by the amount of reserves in the system and the money multiplier.In conclusion, banks create money through the process of fractional reserve banking, which allows them to create and lend new money based on a portion of their deposits, leading to an increase in the overall money supply. The money creation process is regulated by the Central Bank, which sets the reserve requirement and controls interest rates to manage the money supply and maintain economic stability.
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