Assumption of Money Creation or Credit Creation

Assumption of Money Creation

The assumption of money creation is based on the concept that the central bank has the power to create money. This power is derived from the fact that the central bank is the only institution that can issue legal tender. The following are the assumptions of money creation:

1. Central Bank Control

The central bank has the power to control the amount of money in circulation. The central bank can increase or decrease the money supply by changing the reserve requirements of commercial banks.

2. Fractional Reserve Banking

Commercial banks operate on a fractional reserve basis, which means that they only keep a fraction of the deposits they receive as reserves. The rest of the deposits are lent out, thus creating new money.

3. Money Multiplier Effect

The money multiplier effect is the process by which an initial increase in the money supply leads to a larger increase in the overall money supply. This is because the banks lend out the new deposits they receive, creating even more deposits and expanding the money supply.

Assumption of Credit Creation

The assumption of credit creation is based on the concept that banks are the primary source of credit in the economy. The following are the assumptions of credit creation:

1. Demand for Credit

The demand for credit from borrowers is the primary driver of credit creation. As borrowers seek loans from banks, the banks create new credit by extending loans to meet this demand.

2. Bank Lending Standards

Banks have lending standards that determine the creditworthiness of borrowers. These standards ensure that loans are made to borrowers who are likely to repay them, reducing the risk of default and ensuring that credit creation is sustainable.

3. Reserve Requirements

Banks are required to hold a certain amount of reserves to ensure that they can meet their obligations to depositors. However, the reserve requirements also limit the amount of credit that banks can create.

In conclusion, both money creation and credit creation assumptions are based on the power and control of the central bank and commercial banks in the economy. While money creation focuses on the central bank's ability to control the money supply, credit creation focuses on the banks' ability to create credit through lending activities.