Money Creation
Money creation refers to the process through which new money is introduced into the economy. It involves the creation and circulation of money by central banks and commercial banks. The primary goal of money creation is to facilitate economic activities and maintain price stability.
Central Bank Money Creation
The central bank plays a crucial role in money creation by controlling the money supply in an economy. It creates money in the form of currency notes and central bank reserves, which are held as deposits by commercial banks.
1. Open Market Operations: The central bank purchases government securities (bonds) from commercial banks and individuals in the open market. In return, the central bank credits the accounts of the sellers with new reserves, effectively increasing the money supply.
2. Reserve Requirements: Central banks set reserve requirements, which specify the minimum amount of funds that commercial banks must hold as reserves against their deposits. When banks receive deposits, they are required to keep a certain percentage of those deposits as reserves. The remaining funds can be loaned out, effectively creating new money.
Commercial Bank Money Creation
Commercial banks also contribute to money creation through their lending activities. When banks make loans, they create new deposits in the borrower's account, effectively increasing the money supply.
1. Fractional Reserve Banking: Commercial banks operate on a fractional reserve system, which means they are required to hold only a fraction of their deposits as reserves. For example, if the reserve requirement is 10%, a bank can loan out 90% of the deposits it receives. This process multiplies the initial deposit and creates new money.
2. Deposit Expansion: When a loan is made, the borrower receives the loan amount in their account, which becomes a new deposit. The borrower can then use this money to make purchases or payments, effectively increasing the money supply. This process can continue as the deposited money is used and re-deposited in other accounts, leading to further money creation.
Example and Calculation:
Let's assume a bank receives a deposit of $100. Based on a reserve requirement of 10%, the bank is required to hold $10 as reserves and can lend out the remaining $90. Suppose the borrower spends this $90 by purchasing goods from a business, which then deposits the money into their account. The bank can now use this new deposit to make additional loans.
The initial deposit of $100 has led to an increase in the money supply by $90. If this process continues, the money supply will continue to expand, resulting in multiple rounds of money creation.
In conclusion, money creation is the process by which new money is introduced into the economy. It involves the central bank's open market operations and reserve requirements, as well as commercial banks' lending activities. Through fractional reserve banking and deposit expansion, the initial deposit can lead to a multiplication of the money supply, promoting economic growth and stability.