Question

11. With reference to the money multiplier and bank lending activity, explain the money creation process, i.e., how do banks “create” money? What role do excess reserves in the banking system play in this process? The money multiplier?

Answer 1

ANSWER - The money multiplier measures the rate at which the money is created by the commercial banks through lending and reserves. It can be measured as -

1 / reserve ratio

Now suppose we have initial deposit of $ 10000 and the reserve rate is 20%. Then 2000 will be the reserves and remaining 8000 will be given as loans by the bank. Hence the total money created = 1 / 20% * 10000

Hence the total amount comes out to be $ 50000. The multiplier will be 1 / 0.20 = 5

The excess reserves help the bank in emergency situation. In case if the bank suffer any heavy losses then with the help.of excess reserves the debts can be paid and the functioning of the banks will not be affected.