Money Creation by Commercial Banks (HL)

This page is for Higher Level students only.

One of commercial banks' most important tasks is that they create credit.

If a customer deposits $100 in a bank, the bank can lend that money out to someone else, charging interest for it. Part of this interest is returned to the original customer. The borrower now has money, which they then deposit in a bank. The bank can then lend that money out to a second borrower, and so on. 

This may sound complicated, but here is a nifty diagram to explain it (scroll down):

1. Person 1 deposits $100 into Bank A.

2. The bank is obliged to keep at least 10% of this deposit safe somewhere, and is able to lend out the rest.

3. Hence, $90 is lent out to Person 2, who then needs a place to keep that money. Person B therefore deposits this loan into Bank B.

4. Bank B, like any other bank, must keep 10% of its deposits safe, so it can lend out $81 to Person C. 

5. Person C now has $81 and can put that into Bank C, who does the same thing as Bank A and Bank B. 

6. The cycle repeats infinitely.

This is how an initial deposit of $100 can actually create much more value in the economy thanks to commercial banks. 

In order to find this value, use the money multiplier formula:

Money Multiplier = 1 / Reserve Ratio

So in the previous example, the money multiplier is 1 / 0.1 = 10. So for every $100 deposited the economy actually has 10x100 = $1000. This means that an additional $900 is made by commercial banks from just a $100 deposit.

This is why the minimum reserve ratio is an important part of monetary policy. If the ratio increases, the amount of money banks can create decreases. If the ratio decreases, banks can lend out more money, creating more. 

Low MMR = More money creation = More money = Cheaper borrowing = Cheaper investing = higher real GDP