Question
Fri April 04, 2014 By: Swarupa Tamuli

How does commercial bank create money?

Expert Reply
Wed April 16, 2014

Commercial banks create money in the economy by providing loans.  

Loans are lent to consumers by commercial banks in the form of various loans - car loans, mortgages, business loans, home equity loans and personal loans. The money allocated for these loans comes from the deposits of other clients of the bank. As the bank is aware that these funds are most likely to remain stagnant for a given period, a definite amount of funds is lent to others, who are then expected to repay their loans with interest. Thus, the bank collects interest on the money of its depositors without risking any actual money of its own. In this manner, the funds of one depositor are used to finance the loans of several customers of the bank. Moreover, the bank gets money from the interest collected from the individual to whom the loan was lent.

Let us understand it better with the help of an example.

Let Rs 100 be deposited into the bank by a depositor. The bank is aware that this depositor is unlikely to withdraw more than Rs 10 in the near future. It therefore puts Rs 10 in reserve and gives a loan of Rs 90 to X and enters the sum in his/her account. Because the bank knows that X will not use Rs 90 soon, it gives a loan of Rs 81 to Y by creating a deposit in Y's name and keeps aside Rs 9 in reserve. Theoretically, this process is carried out until no more excess reserves are left in the bank.

Thus, now the bank has three account holders with Rs 100, Rs 90 and Rs 81 in their accounts which is equal to Rs 271. This shows that the bank with the initial Rs 100 has now created a new deposit of Rs 271. This is the way banks create money.

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