Question

How do banks create money and what determines how much money banks create?

Answer 1

Banks can create money by giving out loans from the amount that is deposited in the bank after saving a required proportion for precautionary purposes. Suppose the reserve requirement is 10% and the bank receive $10,000 as deposit then it will save $1,000 (10% of $10,000) as reserves and lend out the remaining $9,000. When the loan will be repaid then the bank will take out a required proportion from that as well in reserves and again lend that amount and this process will go on. The money creation takes place in multiples. The multiplier can be calculated as 1/r where r is the required reserve ratio. So, the value of multiplier in this case is 10. Therefore, the total increase in money supply after lending out $9,000 is (10)(9,000) = $90,000. So, in this way the banks create money.