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Money creation process

Most of the modern money is in the form of paper money, promissory notes issued by central banks, and most often partially backed by reserves. Since banks do not expect all their depositors to come asking for their money at the same time, they would rather lend the excess money to earn interest instead of keeping it in their vaults. The process is called credit creation and it depends on reserve requirements, the percentage of deposits a bank is required to maintain in cash.

$$ Money\ Created=\frac{Initial\ Deposit}{Reserve\ Requirement} $$

For example, let’s imagine there is a single bank in the country whose central bank has a 20% reserve requirement. If it receives $100 as deposit, it can keep USD 20 (=20% × USD 100) as cash and lend the rest i.e. USD 800 to Firm A. If Firm A deposits USD 800, the bank can lend a further USD 640 (=80% × USD 800) to Firm B. If Firm B deposits $640, it can lend a further USD 512 to Firm C, and so on. This process culminates in a total money creation of USD 5,000 (= USD 1,000/20%).

The money multiplier is the inverse of reserve requirement and it shows the number of dollars of money created per dollar of initial deposit.

If a country has a reserve requirement of 15%, money created in the third round of credit creation in response to a USD 100,000 initial deposit would be:

A) USD 72,250
B) USD 61,412
C) USD 666,667

Show answer

B is correct. Money created in the first round is $85,000 (=$100,000 × 85%), second round is $72,250 (=$85,000 × 85%) and third round is $61,412 ($72,250 × 85%).

by Obaidullah Jan, ACA, CFA on Tue Feb 11 2020

This article can help you prepare for Reading 16 LOSc.

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