Question

In what ways can the Federal Reserve System or any central bank influence the money and credit creation process?

Answer 1

The central bank or Federal reserve can aid in the money creation or credit creation process through the fractional reserve theory. For example, when people deposit money in a bank, then based on instructions of central bank, a certain proportion can be lent by the bank to other parties which kickstart the cycle.

To give an example, let us assume that the reserve ratio set by Federal Reserve is 10%. Then out of the $100 available deposits, bank can keep $10 as reserves and loan the $90 to others. Then out of this $90, $50 can be deposited in the bank and $40 invested in buying machinery. So the total money supply in the economy has increased from $100 to:

Reserves: $10
Loan by bank: $90
Deposits in the bank:$50
Total: $150

Thus money supply has increased because of fractional reserve theory.