Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

Money Creation Process

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 customers’ withdrawal requests.

Banks usually lend customers’ money to others, assuming that all customers won’t withdraw their money simultaneously. 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: 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.

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

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 can affect 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 1

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


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 by depositing an additional $1000 into a deposit account.

A. $5,000

B. $18,000

C. $20,000


The correct answer is A

Recall that to calculate the amount of money created, we use the formula:

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

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep

    Sergio Torrico
    Sergio Torrico
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.