Banks and money are inextricably linked. In our economy, the majority of the money creation by banking system is done in the form of bank deposits. It's not just that the majority of money is held in bank accounts. Through the process of making loans, the banking system can literally create money. Every new loan made by a bank generates new money. While this is often difficult to believe at first, it is common knowledge among those in charge of the banking system.

What is Money Creation by Banking System?

• Banks can lend money because they do not expect all investors and depositors to withdraw their funds at the same time.
• When a bank lends money to someone, a new deposit is opened in that person's name. As a result, the money supply expands to include both old and new deposits (plus currency).
• Let's look at an example. Assume there is only one bank in the country. Let's create a fictitious balance sheet for this bank only. The balance sheet is a record of an enterprise's assets and liabilities.
• Traditionally, assets are recorded on the left side of the balance sheet, while liabilities are recorded on the right.
• Accounting rules require that both sides of the balance sheet be equal and tally, or that total assets equal total liabilities.
• Assets are items that a company owns or has the right to claim from others. A bank's assets, aside from buildings and furniture, are the loans it makes to the public. When a bank makes a ₹1,000 loan to a person, this is the bank's claim on that person for ₹1,000.
• Reserves are another type of asset that a bank has. Reserves are commercial banks' deposits with the Central Bank, the Reserve Bank of India (RBI), and its cash.
  • These reserves are kept partly in cash and partly in the form of financial instruments issued by the RBI, such as bonds and treasury bills.
• Reserves are similar to the deposits we make at banks. We keep deposits, and these deposits are our assets, which we can withdraw. Similarly, commercial banks such as the State Bank of India (SBI) maintain their deposits with RBI which are called reserves.

Assets = Reserves + Loans

• Any business's liabilities are its debts or what it owes to others. The main liability of a bank is the deposits that people keep with it.

Liabilities = Deposits

• According to the accounting rule, both sides of the account must balance. As a result, if assets exceed liabilities, they are recorded on the right-hand side as Net Worth.

Net Worth = Assets - Liabilities

Financial Intermediation

• The ability of banks to create money distinguishes them from other financial intermediaries.
• Financial markets play an important role in transferring surplus reserves from households that save some of their income for the future to households and firms that want to borrow to buy investment (capital) goods for future production.
• Financial intermediation refers to the process of transferring funds from savers to borrowers.
• Only banks have the legal authority to create assets that are part of the money supply, such as deposits withdrawable by cheque, among all financial intermediaries, including the stock market, bond market, investment companies, and mutual funds.
• This means that banks are the only financial institutions that have a direct impact on the money supply.

Money Creation vs Wealth Creation

• Without a doubt, the fractional-reserve banking system generates money. However, it does not generate wealth.
• When a bank lends a portion of its excess reserves, it provides borrowers with the ability to conduct transactions and, as a result, increases the country's money supply.
• However, because the borrowers also have a debt obligation to the bank, the loan does not make them richer.
• This simply means that the banking system's creation of money increases the economy's liquidity rather than its wealth.

Determinants of Money Creation

Excess Reserves

• The total amount of excess reserve held by the banking system as a whole per period determines banks' credit-creating capacity.
• The amount of deposit created is proportional to the amount of excess reserve.

Reserve Ratio

• The maximum amount of credit that banks can create is also determined by the reserve ratio maintained by the banking system as a whole.
• If the central bank raises the minimum-reserve ratio, the total amount of deposits created by the banking system falls. The opposite is also true.

Banking Habits of People

• The credit-creating capacity of commercial banks is also affected by people's banking habits.
• People's banking habits are well-developed in industrialised countries, and the majority of transactions are settled with cheques.
• Obviously, commercial banks' credit-creating capacity is greater in such countries.
• The opposite is true in developing countries such as India. Banking services are not available in the majority of rural areas, where 70% of the population lives. Furthermore, thebanking habits are alsounderdeveloped in such countries.
• In fact, the prevalence of the barter system and a lack of monetisation in the majority of developing Asian, Latin American, and African countries obstructs multiple credit expansion by the banking system.

Availability of Collateral Securities

• Banks typically require securities in exchange for making loans.
• If borrowers do not have enough acceptable securities to offer, the total amount of deposits created by the banking system will be small.
• Even if banks are eager to lend, they are unable to increase their loan volume.

Existing Business Conditions

• The amount of credit that the banking system as a whole can create is determined by the state of the economy or, more specifically, by current business conditions.
• When the economy grows, there is more demand for goods and services. Profit prospects will be favourable as a result.
• As a result, business people will be eager to produce more so that they can sell more. As a result, they will take out more loans, increasing the demand for bank loans. This will make it profitable for banks to increase their credit volume.
• Banks, on the other hand, cannot create much credit if the economy is in a slump. It is because there will be little demand for bank loans during these times.

Expansion of Banking System

• The total amount of credit that banks can create is determined by the country's banking system's expansion.
• The credit-creating capacity of banks will be high if the banking system is well-developed and there are many banks in the country.
• It is because the total amount of credit that the banking system as a whole can create is a multiple of the banking system's total excess reserves.
• However, in the system, a single (monopoly) bank cannot create credit (deposits) that exceeds its own excess reserve.

Legal Reserves

• If the legal reserve is 10% but commercial banks keep 20% reserve, the deposit (credit) multiplier is 5, not 10.
• Thus, if a bank's cash deposit increases by, say, Rs. 1,000, the total increase in bank deposit at the end will be only Rs. 5,000, not Rs. 10,000.

Cash Leakage

• Banks will have less cash if depositors withdraw a certain amount of money for spending (transactions).
• As a result, as people's transaction demand for money rises, so will the amount of cash held by the non-bank public.
• This will reduce commercial banks' credit-creation capacity.

Credit Creation by Commercial Banks

• By making new loans, commercial banks generate money in the form of bank deposits.
• When a bank makes a loan, such as to someone taking out a mortgage to buy a house, it does not usually do so by handing over thousands of rupees in banknotes.
• Instead, it credits their bank account with a bank deposit equal to the mortgage amount. New money is created at that point.
• Commercial banks' ability to create credit is determined not only by their own cash requirements, but also by the cash requirements of the public or non-banking system.
• Their own cash requirement is primarily determined by the central bank's monetary (credit) policy.
• In order to slow the economy and control inflation, the central bank frequently limits money supply growth.
• However, the public's cash requirement is determined by transaction demand for money, i.e., the amount of money people require for spending.

Conditions Essential for Credit Creation

The following conditions must be met in order for credit to be created in an economy.

• Public willingness to deposit money in commercial banks.
• Commercial banks' willingness to lend money to individuals or businesses in the form of credit.
• Individuals' or businesses' willingness to seek money from commercial banks in the form of credit.

Flipside

• The flip side of this money creation is that with each new loan comes a new debt.
• This is where our mountain of personal debt stems from: not borrowing from someone else's life savings, but money created out of thin air by banks.

Conclusion

Money can be created because there are multiple banks in the financial system, they are only required to hold a fraction of their deposits, and loans end up deposited in other banks, increasing deposits and, thus, the money supply.

FAQs

Question: What is money creation by the banking system?

Question: How do banks create money through lending?

Question: What is the role of the Reserve Ratio in money creation?

Question: What is the money multiplier effect?

Question: How does the central bank control money creation in the economy?

MCQs

1. Money creation by banks is primarily achieved through:

A) Depositing all money as reserves

B) Lending a portion of their deposits

C) Withdrawing customer savings

D) Purchasing only government bonds

2. The Reserve Ratio affects money creation by:

A) Controlling the amount of money banks can lend

B) Increasing bank profits directly

C) Reducing the number of loans issued

D) Eliminating the need for bank reserves

3. The money multiplier effect is inversely related to:

A) The reserve ratio

B) Inflation rates

C) The number of branches of a bank

D) Government spending

4. Which of the following tools can the central bank use to influence money creation?

A) Increasing the reserve ratio

B) Setting property taxes

C) Regulating internet banking fees

D) Issuing stock market regulations

5. When a bank issues a new loan, it results in:

A) A decrease in the overall money supply

B) An increase in the money supply through new deposits

C) No change in money supply

D) Higher reserves held by the bank

GS Mains Questions and Model Answers

Q1: Explain the process of money creation by commercial banks and its significance in the economy.

Answer: Commercial banks create money through the process of lending, wherein they hold a fraction of deposits as reserves and lend out the remainder. When a bank grants a loan, it creates a deposit in the borrower's account, increasing the overall money supply. This process is repeated as the borrower spends the money, which is deposited into other banks, allowing further lending. This cycle leads to a multiplied increase in the money supply, known as the money multiplier effect. The significance of money creation lies in its ability to influence economic growth, investment, and consumption. By controlling credit creation, the banking system affects liquidity, interest rates, and overall economic activity.

Q2: Discuss the role of the Reserve Ratio in the money creation process and its implications for monetary policy.

Answer: The Reserve Ratio, also known as the Cash Reserve Ratio (CRR), is the portion of deposits that commercial banks are required to keep as reserves with the central bank. It plays a critical role in regulating money creation by determining the amount of funds available for lending. A lower reserve ratio allows banks to lend more, increasing the money supply, while a higher ratio restricts lending and reduces money creation. For monetary policy, adjusting the reserve ratio is a tool used by the central bank to control liquidity, inflation, and economic activity. By tightening or easing reserve requirements, the central bank can influence lending behavior, interest rates, and overall economic stability.

Q3: Analyze the impact of the money multiplier effect on the banking system and the broader economy.

Answer: The money multiplier effect refers to the process by which an initial deposit in the banking system leads to a multiplied increase in the total money supply due to repeated cycles of deposits and lending. This effect is central to the functioning of the fractional reserve banking system. A higher money multiplier indicates that banks are lending more, leading to greater money creation and increased economic activity. This can stimulate growth, investment, and employment. However, excessive money creation may lead to inflation, asset bubbles, and financial instability. Thus, managing the money multiplier through regulatory tools like reserve requirements and interest rates is crucial for maintaining economic balance and stability.

Previous Year Questions on Money Creation By Banking System

1. UPSC CSE 2020

Question: Evaluate the role of commercial banks in the process of money creation and its implications for economic growth.

Answer: Commercial banks play a pivotal role in money creation through the fractional reserve banking system. By lending out a portion of their deposits, banks create new deposits in the economy, effectively increasing the money supply. This process enables greater credit availability, fostering investment, consumption, and economic growth. However, unchecked money creation can lead to inflation, asset bubbles, and financial instability. Therefore, regulatory measures such as reserve ratios and monetary policy tools are essential to ensure a balanced approach to money creation. The impact on economic growth depends on effective regulation, financial stability, and productive use of credit.

2. UPSC CSE 2019

Question: Discuss the significance of the money multiplier effect in the context of money supply and central bank regulation.

Answer: The money multiplier effect describes how an initial deposit in the banking system can lead to a multiplied increase in the total money supply through repeated cycles of lending and deposits. The size of the money multiplier is inversely related to the reserve ratio set by the central bank. A lower reserve ratio results in a higher money multiplier, increasing the money supply, while a higher ratio restricts money creation. This effect is significant for central bank regulation as it influences liquidity, inflation control, and economic stability. By managing reserve requirements and other monetary tools, the central bank can regulate the extent of money creation, ensuring balanced economic growth and stability.