IB DP Economics - Unit 3 - The process of money creation by commercial banks-Study Notes - New Syllabus

The Process of Money Creation by Commercial Banks

Commercial banks play an important role in creating money within the economy.

Money creation occurs mainly through the process of:

• Accepting deposits
• Making loans

When banks provide loans, they create additional deposits in the banking system, increasing the money supply.

Role of Commercial Banks

Commercial banks perform several important functions:

• Accept deposits from customers
• Provide loans to households and firms
• Facilitate payments
• Create credit

The ability to create credit allows banks to expand the money supply.

Fractional Reserve Banking System

The process of money creation operates through the fractional reserve banking system.

Under this system:

• Banks keep only a fraction of deposits as reserves.
• The remaining funds are loaned out.

Reserves

Reserves are funds banks keep:

• As cash in the bank
• As deposits with the central bank

Reserves help banks meet withdrawal demands from customers.

Reserve Ratio

The reserve ratio is the percentage of deposits banks must keep as reserves.

\( \mathrm{Reserve\ Ratio = \dfrac{Reserves}{Deposits} \times 100} \)

Example of a Reserve Ratio

If a bank receives: \( \mathrm{\$10,000} \)

in deposits and the reserve ratio is:

\( \mathrm{10\%} \)

the bank must keep:

\( \mathrm{\$1,000} \)

as reserves and may lend:

\( \mathrm{\$9,000} \)

How Money Creation Occurs

Money creation occurs because loans made by banks are usually deposited back into the banking system.

These deposits then become the basis for further lending.

Step-by-Step Process of Money Creation

Step 1: Initial Deposit

A customer deposits:

\( \mathrm{\$10,000} \)

into Bank A.

If the reserve ratio is:

\( \mathrm{10\%} \)

Bank A keeps:

\( \mathrm{\$1,000} \)

as reserves.

The bank can lend:

\( \mathrm{\$9,000} \)

Step 2: Loan Becomes New Deposit

The borrower spends the:

\( \mathrm{\$9,000} \)

and the money is deposited into Bank B.

Bank B keeps:

\( \mathrm{10\% \times 9,000 = \$900} \)

as reserves and lends:

\( \mathrm{\$8,100} \)

Step 3: Repeated Lending Process

The process continues throughout the banking system.

Each bank:

• Keeps a fraction as reserves
• Lends the remainder

This repeatedly expands deposits and money supply.

Money Multiplier

The total increase in money supply depends on the money multiplier.

\( \mathrm{Money\ Multiplier = \dfrac{1}{Reserve\ Ratio}} \)

The reserve ratio must be written as a decimal.

Example of the Money Multiplier

If the reserve ratio is:

\( \mathrm{10\% = 0.10} \)

then:

\( \mathrm{Money\ Multiplier = \dfrac{1}{0.10} = 10} \)

This means the banking system can potentially create up to:

\( \mathrm{10 \times} \)

the original deposit in total money supply.

Maximum Money Creation

The maximum increase in money supply can be calculated using:

\( \mathrm{Maximum\ Money\ Creation = Initial\ Deposit \times Money\ Multiplier} \)

Example:

Initial deposit:

\( \mathrm{\$10,000} \)

Reserve ratio:

\( \mathrm{10\%} \)

Money multiplier:

\( \mathrm{10} \)

Maximum money creation:

\( \mathrm{\$10,000 \times 10 = \$100,000} \)

Important Assumptions of the Money Multiplier Process

The theoretical maximum money creation assumes:

• All excess reserves are loaned out.
• All loans are redeposited into banks.
• Banks lend all available excess reserves.
• No cash leakages occur.

Leakages in the Money Creation Process

In reality, money creation is usually smaller because of leakages.

Examples of Leakages

• People may keep cash instead of redepositing money.
• Banks may hold excess reserves.
• Borrowers may not spend all borrowed funds immediately.

These leakages reduce the actual multiplier effect.

Role of the Central Bank

The central bank influences money creation through:

• Reserve requirements
• Interest rates
• Monetary policy

Higher Reserve Ratios

If the central bank increases reserve requirements:

• Banks lend less.
• Money creation decreases.

Lower Reserve Ratios

If reserve requirements decrease:

• Banks can lend more.
• Money creation increases.

Importance of Money Creation

Money creation supports:

• Economic growth
• Investment
• Consumption
• Business activity

However, excessive money creation may contribute to inflation.

Advantages of Commercial Bank Money Creation

• Provides funds for investment and consumption
• Supports economic growth
• Improves liquidity in the economy

Potential Risks

• Excessive lending may create inflation.
• Risky lending may create financial instability.
• Bank failures may reduce confidence in the financial system.

Summary of the Money Creation Process

Key Ideas:

• Commercial banks create money through lending.
• The process operates through fractional reserve banking.
• The reserve ratio determines the size of the money multiplier.
• Loans create new deposits and expand money supply.
• The central bank influences money creation through monetary policy and reserve requirements.