The Money Creation Process

The money creation process is very helpful in understanding the role of money in the economy. The strength of money creation is influenced by the amount kept in the bank as a reserve for meeting the withdrawal requests of customers.

Banks usually lend customers’ money to others, assuming that all customers won’t withdraw their money at the same time. This concept is called fractional reserve banking. For instance, a banker in an economy may retain 20% of customers’ deposits as the reserve requirement. When customers deposit €100 in Bank A, the deposit changes the balance sheet of Bank A. When the bank lends 20 percent of its deposit to another customer, it creates two types of assets:

1. the bank’s reserve of €20; and

2. a loan of €80.

Example of the Money Creation Process

Assume that Bank A received a deposit of €50 from a customer. Following the principle of fractional reserve banking, the money will be created in the following way, if 20% of the deposit is set aside as the reserve requirement.

$$
\begin{array}{c|c}
\textbf{Bank A} & \\
\text{Assets} (\unicode{0x20AC}) & \text{Liabilities} (\unicode{0x20AC}) \\
\text{Reserve: 10} & \text{Deposit: 50} \\
\text{Loan: 40} & \\
\hline
\textbf{Bank B} & \\
\text{Assets} (\unicode{0x20AC}) & \text{Liabilities} (\unicode{0x20AC}) \\
\text{Reserve: 8} & \text{Deposit: 40} \\
\text{Loan: 32} & \\
\hline
\textbf{Bank C} & \\
\text{Assets} (\unicode{0x20AC}) & \text{Liabilities} (\unicode{0x20AC}) \\
\text{Reserve: 6.4} & \text{Deposit: 32} \\
\text{Loan: 25.6} & \\
\hline
\textbf{Bank D} & \\
\text{Assets} (\unicode{0x20AC}) & \text{Liabilities} (\unicode{0x20AC}) \\
\text{Reserve: 5.12} & \text{Deposit: 25.6} \\
\text{Loan: 20.48} & \\
\hline
\end{array}
$$

On the balance sheet, there are assets worth €50 and liabilities worth €50 resulting from the initial deposit received by Bank A. Bank A kept 20% (€10) of the deposit as a reserve requirement, and loaned the remaining 80% (€40) to a customer. The customer made a business transaction with the loan, and the recipient of the €40 further deposited the money into their bank account (Bank B). Bank B kept 20% (€8) of the deposit as the reserve requirement and then loaned the remaining 80% (€32) to a customer, and so on until there is no more money to be deposited and loaned out.

How Much Money is Created?

In each circle, the bank keeps 20% of the deposit it receives, and this will continue until there is no more money left to be deposited and loaned out. This shows how money is created by banks offering loans from money deposited by their customers. The amount of money created from one deposit is calculated by dividing the reserve requirement ratio by the deposit. That is:

$$\text{Money created} =\frac{\text{New deposit}}{\text{Reserve requirement}}$$

From the example above, it is:

$$\text{Money created} =\frac{€50}{0.20} = €250$$

Money Multiplier

This is the function of 1 divided by the reserve requirement, known as the money multiplier. That is:

$$\text{Money Multiplier} =\frac{1}{\text{Reserve requirement}}$$

For the example above, the money multiplier is, therefore:

$$\text{Money Multiplier} =\frac{1}{0.20} = 5$$

The amount of money created by the banking system through the practice of fractional reserve banking is a function of 1 divided by the reserve requirement, and it is called the money multiplier. In some economies, the central bank sets the reserve requirement, which is a potential means of affecting the economy’s growth.

Note that the higher the reserve requirement of the bank, the lesser the multiplier effect; that is, the lesser the money that can be created.

Question

Given a 5% reserve requirement, what new deposit amount will lead to money created amounting to €100,000?

A. €5,000

B. €200,000

C. €2,000,000

Solution

The correct answer is A.

To calculate money created from addition deposit in the banking system, we use the following formula:

$$\text{Money created} = \frac{\text{New deposit}}{\text{Reserve requirement}}$$

$$€100,000 = \frac{\text{New deposit}}{0.05}$$

Rearranging the formula:

$$\text{New deposit} = €100,000\times 0.05 = €5,000$$

Question 2

The reserve requirement for banks in a certain African economy is 20%. Calculate the amount of money that could be created with the deposition of an additional $1000 into a deposit account.

A. $5,000

B. $18,000

C. $20,000

Solution

The correct answer is A

Recall that:

To calculate the amount of money created, we use the formula:

$$\text{Money created} =\frac{\text{New deposit}}{\text{Reserve requirement}}=\frac{1000}{0.2}=5000$$

Reading 16 LOS 16c:

Explain the money creation process