Question

Discuss role play by Bank in the monetary system? How do bank create money?

Answer 1

The success of any monetary system depends on the strong and vibrant banking system. The banking system gathers money from the surplus sector and provides a fund to the deficient sector.  

Effectiveness of any monetary policy depends on the banking sector. If role of banking sector is dominant, the change in monetary policy would get reflected in economy correctly. If banking sector role is not dominant, the monetary policy would not be very effective.

Bank creates money through the credit creation.

Every bank is required to keep a certain part of deposit as the reserve and lend out rest of the amount. When bank lends out money, it creates the deposit in the name of borrowers, so eventually, now new deposit is created. Bank keeps a certain percentage of newly created deposits as a reserve and lends out rest of amount. The same process keeps moving. Actual capacity of bank to lend out depends on the reserve ratio. A higher reserve ratio reduces the lending capacity of bank.

In this way, money is created by the bank. Bank creates money but does not create wealth in this process.