a) Explain how one bank create

a) Explain how one bank creates money

b) how does the banking system creates money?

c) Define the money multiplier and explain why themultipler is likely to overstate the actual Increase in the moneysupply


a) Suppose a bank has, hypothetically, $10 million as deposits.This bank is required to have 10% of the total deposits as reservesto cover withdrawals. The reserve amount is equal to $1 million.The bank is allowed to lend the remaining $9 million to anyone whoneeds it. The loan of $9 million will fetch the bank interestpayments. This is the how the bank will create money beyond the $10million it initially had.

b) Now suppose, the business to which this $9 million was loanedout to deposits this sum to another bank, say Bank 2. 10% of thissum is kept as reserves in Bank 2. It leaves Bank 2 with $8.1million to lend. This sum of money when loaned out then generatesinterest income for Bank 2.

This chain goes on, with Bank 2 lending to Bank 3. Bank 3keeping 10% reserve and lending out the rest to Bank 4, which inturn keeps 10% deposit and so on…..

This is how money is created in the banking system.

c) As we saw, with each successive bank keeping a reserve amountand lending the rest, the money supply is expanding. The amount ofmoney that the system can create is found by using the moneymultiplier. The money multiplier tells us by how many times a loanwill be “multiplied” through the process of lending out excessreserves, which are deposited in banks as demand deposits. Thus,the money multiplier is the ratio of the change in money supply tothe initial change in bank reserves.

Money multiplier is = 1/Required Reserve Ratio

The required reserve ratio is 10%, then the money multiplier is= 1/0.1 = 10, i.e. the money supply will increase by 10 times!

This increase in the money supply is actuallyover-estimated by the multiplier because themultiplier formula does not take into account the excess reservesthat banks keep. Excess reserves are capitalreserves held by a bank or financial institutionin excess of what is required by regulators,creditors or internal controls. Also, the central bank does notreally have, in real life, full control on the monetary base.

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