1.1. Money or Credit Creation Process

The process of money creation is a crucial concept for understanding the role that money plays in an economy. Its potency depends on the amount of money that banks keep in reserve to meet the withdrawals of its customers. This practice of lending customers’ money to others on the assumption that not all customers will want all of their money back at any one time is known as fractional reserve banking.

We can illustrate how it works through a simple example. Suppose that the bankers in an economy come to the view that they need to retain only 10 percent of any money deposited with them. This is known as the reserve requirement. Now consider what happens when a customer deposits Rs. 100 in Bank X. This deposit changes the balance sheet of Bank X and it represents a liability to the bank because it is effectively loaned to the bank by the customer. By lending 90 percent of this deposit to another customer the bank has two types of assets: (1) the bank’s reserves of Rs. 10, and (2) the loan equivalent to Rs. 90.

Now suppose that the recipient of the loan of Rs. 90 uses this money to purchase some goods of this value and the seller of the goods deposits this Rs. 90 in another bank, Bank Y. Bank Y goes through the same process; it retains Rs. 9 in reserve and loans 90 percent of the deposit (Rs. 81) to another customer. This customer in turn spends Rs. 81 on some goods or services. The recipient of this money deposits it at the Bank Z, and so on.

This process continues until there is no more money left to be deposited and loaned out. The total amount of money ‘created’ from this one deposit of Rs. 100 can be calculated as:

New deposit/Reserve requirement = Rs. 100/0.10 = Rs. 1,000

It is the sum of all the deposits now in the banking system. Also note that the original deposit of Rs. 100, via the practice of reserve banking, was the catalyst for Rs. 1,000 worth of economic transactions. That is not to say that economic growth would be zero without this process, but instead that it can be an important component in economic activity.

The amount of money that the banking system creates through the practice of fractional reserve banking is a function of 1 divided by the reserve requirement, a quantity known as the money multiplier. In the case just examined, the money multiplier is 1/0.10 = 10.

In our simplistic example, we assumed that the banks themselves set their own reserve requirements. However, in some economies, the central bank sets the reserve requirement, which is a potential means of affecting money growth. In any case, a prudent bank would be wise to have sufficient reserves such that the withdrawal demands of their depositors can be met in stressful economic and credit market conditions.