Understanding Credit Creation by Commercial Banks
Credit creation is a fundamental function of commercial banks, allowing them to expand the money supply in the economy. Here’s how it works:
1. Accepting Deposits
- Commercial banks start the credit creation process by accepting deposits from customers.
- These deposits can be in the form of savings accounts, current accounts, or fixed deposits.
2. Reserve Requirement
- Banks are required to hold a certain percentage of deposits as reserves, known as the reserve requirement.
- This reserve is kept with the central bank and is not available for lending.
3. Loan Issuance
- The remaining portion of the deposits, after setting aside the reserve, can be loaned out to borrowers.
- For example, if a bank has $1,000 in deposits and the reserve requirement is 10%, it must keep $100 and can lend out $900.
4. Money Multiplier Effect
- The money lent out can be deposited back into the banking system, creating a cycle of deposits and loans.
- This process continues, allowing banks to create multiple layers of credit, known as the money multiplier effect.
5. Impact on Money Supply
- Through this process, commercial banks can significantly increase the total money supply in the economy.
- The initial deposit leads to a much larger increase in the overall money supply as loans are re-deposited and re-lent.
6. Economic Implications
- Credit creation supports business investments, consumer spending, and overall economic growth.
- However, excessive credit creation can lead to inflation and financial instability.
By understanding this process, one can appreciate the crucial role that commercial banks play in the economy through credit creation.