Commercial banks play a crucial role in the economy by creating money through the process of credit creation. This ability allows banks to expand the money supply beyond the physical currency issued by the central bank. In this article, we will explore how commercial banks create money and its impact on the economy.
What is Money Creation?
Money creation refers to the process by which commercial banks generate new money in the form of bank deposits through lending activities. This does not mean printing physical currency but rather increasing the amount of money available in the economy.
Process of Money Creation by Commercial Banks
1. Primary Deposits
When a customer deposits cash in a bank, it is known as a primary deposit. This deposit does not create new money; it simply transfers existing money into the banking system.
2. Loan Creation and Credit Expansion
Banks use a portion of these deposits to provide loans to borrowers. When a bank grants a loan, it does not give physical cash but rather credits the borrower’s account with a new deposit. This new deposit acts as money, even though no physical cash has been created.
3. The Money Multiplier Effect
Since banks are required to keep only a fraction of their deposits as reserves (as mandated by the central bank), they can lend out the rest. This process continues as borrowers deposit their loaned money into other banks, which then lend further, leading to multiple rounds of money creation.
The total amount of money that can be created is determined by the money multiplier formula:
Money Multiplier = 1 / Reserve Ratio
For example, if the reserve requirement is 10% (0.1):
Money Multiplier = 1 / 0.1 = 10
This means that for every Tk. 100 deposited, the banking system can create up to Tk. 1,000 in new money through repeated lending and depositing.
Effects of Money Creation
1. Boosts Economic Growth – More money in circulation increases investment and consumption, driving economic expansion.
2. Can Cause Inflation – Excessive money creation can lead to inflation if it surpasses economic output.
3. Affects Interest Rates – More money supply generally lowers interest rates, making borrowing cheaper.
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Conclusion
The ability of commercial banks to create money through lending is essential for economic development. However, central banks regulate this process to maintain financial stability and prevent inflation. Understanding how money creation works helps us better grasp the functioning of modern banking and its impact on the economy.
