How money creation is done in the economy? (PART-1- Commercial Banks)

    Money creation is a method followed by banks to introduce some money into the economy. This happens when there is a shortage of money or when the economy is slowing down. Money can be introduced into the economy by printing it (by purchasing bonds), and by giving loans out of the deposit or thin air. One of the most followed methods that generate huge amounts of money creation is by giving loans. Let’s take a look at it.

LOANS

Loans are one of the best methods of introducing money into the economy. It is generally created by commercial banks without introducing new money into the economy. One of the popular loan methods which create money is Fractional Reserve Banking. It is the type of Banking, in which a portion of the customer’s deposit is maintained as a reserve and the remaining is lent out as a loan. Let’s figure that out with an example. Let’s say a person deposits $100 in Bank A. Now this $100 does not sit simply in the person’s bank vault; rather only a portion of its maintained. This portion is called the required reserve, which is maintained for the customer’s urgent needs (if the customer wants to withdraw their money immediately). This required reserve should be of a certain percentage (10% in the US) in some countries.

So in this example, $10 is deposited in the person’s vault, while the remaining 90% ($90) is lent out as a loan to another person. Now the person, who has got some loan, suffices his expenses by buying some goods for his life. Let’s say he bought a nice watch from a watch company. Now the watch company owner does not simply put that $90 in his pocket, rather he deposits it in his own bank. Let’s say it was Bank B. Now that Bank B deposits 10% of the money ($9) in his vault and lends the other 90% ($81) as a loan to another person. Now the other person gets the loan and buys another good (let’s say a shoe from a Shoe Company). Now the shoe company owner deposits the $81 in Bank C. Again the required reserve is maintained, and the loan process is carried out continuously. You can see the process in detail, in the below diagrammatic representation.

Process of Fractional Reserve Banking

Now the important thing that needs to be considered in the concept of Fractional Reserve Banking is; that new money is created during each new loan given. Let’s consider the above example. During each loan, 10% of the reserve is kept and the remaining is lent out as a loan. This loan is added to the deposit account and the number of deposits is increased. So even though the same $100 is distributed to everyone, each one will be mentioned as the sum of the amount they deposited. So by calculating the number of deposits, we can see the increase in the money supply. To find out, how much is increased in circulation, we can use the money multiplier effect.

Money Multiplier = 1/10% (Reserve Ratio) =10

    It states that, if we deposit $1 in the bank; due to fractional banking, the money multiplier effect will convert that $1 into $10. This money output is related to the reserve ratio, the bank has maintained. If the reserve ratio is higher, the money output will be low as the loan amount granted will be low. Alternatively, if the reserve ratio is lower, vice versa happens.

Money multiplier Effect

    There is also another type of multiplier called the Spending multiplier. It is the type of multiplier which is regarded to the spending of the people (Consumer spending). It is not related to banking, but important for economic growth. So as spending increases, the economy grows and that’s what the government needs. To know more about how consumer spending increases the economy, please visit the previous article.

https://sciencetopic03.blogspot.com/2021/11/contribution-of-different-factors-to.html

    We can simply differentiate the money multiplier and the spending multiplier as monetary policy and fiscal policy. The Monetary policy is taken care of by the central bank, which uses the money multiplier to create money. Whereas, the fiscal policy is taken care of by the central government, which uses the spending multiplier to grow the economy. The Monetary Policy handled by the Central Bank monitors the cash flow and the interest rates over the banks; whereas the fiscal policy handled by the central government controls the economy, by altering taxes and consumer spending. As same as the money multiplier, the spending multiplier has too a formula, which is given by,

Spending multiplier =1/Mpc

    The Mpc (Marginal Propensity to consume) is the amount we consume (let’s say in terms of $1). If we consume $0.5 and save $0.5 (Mps-Marginal Propensity to save) then,

Spending multiplier=1/0.5=2

This means, that if the government increases spending by 5 million dollars, it becomes 10 million dollars in the total spending of that money. The spending multiplier is not used in the banking system. It was just used as a tool to measure the economic growth of a country.

But the method of money multiplier was unpopular among banks as it has so many disadvantages. One of the main disadvantages is, that it depends upon the deposit of the people which is divided into reserves and loans. If there were no deposits produced, there will be no loans produced. So banks will face a decrease in the money supply. For this purpose, banks follow another method, in which they do not keep up the reserves, and lend out the loan as much as they can out of thin air. This process is simply done by adding numbers to the digital platform. The only limit for this type of money creation is the bank's confidence in giving out loans and the demand for loans. If the loans were less, there will be no money supply; and if the loans were more there will be vice versa.

 But in this system, you can question about the reserve requirement, as it is the only main thing to satisfy the needs of the people when there is an emergency. But in this method, there is no critical value of storage reserve is maintained, and the banks give loans irrespective of the reserve requirement. So if there is an urgent need, it is later borrowed from another bank at a nominal interest. But this interest is lower, compared to the interest rate it charges over loans to customers. The transfer of amounts from bank to bank is called interbank lending, and this is done through the central bank cash reserve. The central bank cash reserve is the reserve allotted by the Central bank to each commercial bank. It is only used for interbank lending. This cash reserve in the central bank is the national debt, and it is created by buying bonds from commercial banks.

Money Creation in the economy (Interbank Lending)

    As far as we saw, that the money is been circulated back and back to create extra money in circulation. This method is fine till the central bank reserve is good enough and there is no urgent need for extra money. But, what if the demand was more and there was more population, and there was a huge price hike, and the banks couldn’t give out loans as before to improve the economy. That’s where new money comes in from the central governmental bonds. In this method, the bonds are exchanged with money, to increase money circulation. We can discuss this concept clearly in our next article.

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