Money Creation Formula

The money creation process refers to the ability of commercial banks to create money through the issuance of loans. The formula for money creation can be summarized as follows:

Money Creation = Initial Deposit * (1 / Reserve Requirement)

The initial deposit represents the amount of money deposited by an individual or business into a bank. The reserve requirement is the percentage of deposits that banks are required to hold as reserves. The remaining percentage of the deposit can be used for lending and creating new money.

Example Calculation

Let's consider an example to understand the money creation process. Suppose an individual, John, deposits $10,000 into his bank account. The reserve requirement set by the central bank is 10%.

Step 1: Initial Deposit
John deposits $10,000 into his bank account.

Step 2: Reserve Requirement
The reserve requirement is 10%, which means the bank must hold 10% of John's deposit as reserves. In this case, the bank must hold $1,000 (10% of $10,000) in reserves.

Step 3: Money Creation
The remaining $9,000 ($10,000 - $1,000) can be used for lending. When the bank lends this money to another individual, let's say Sarah, the money supply increases.

Step 4: Recipient's Bank Deposit
Sarah receives a loan of $9,000, which is deposited into her bank account.

Step 5: Reserve Requirement for the Recipient's Bank
The recipient's bank must also hold a percentage of Sarah's deposit as reserves, as per the reserve requirement. Following the same 10% reserve requirement, Sarah's bank must hold $900 (10% of $9,000) as reserves.

Step 6: Money Creation (Continued)
The remaining $8,100 ($9,000 - $900) can be used for further lending by Sarah's bank, contributing to the expansion of the money supply.

Step 7: Repeating the Process
This process continues as banks lend out the remaining deposits, and new deposits are created, leading to the creation of additional money.

Conclusion

The money creation process is based on the fractional reserve banking system, where banks are required to hold only a fraction of deposits as reserves. By utilizing this system, banks can create new money through lending, contributing to the expansion of the money supply in the economy. However, it is essential for central banks to regulate and monitor this process to maintain stability and prevent excessive money creation, which can lead to inflationary pressures.