The role of commercial banks in creating money

The role of commercial banks in creating money

The role of commercial banks in creating money

Commercial banks play a crucial role in the creation of money within an economy. Through a process called fractional reserve banking, these banks are able to expand the money supply by creating additional money in the form of bank deposits. This process has a significant impact on the overall functioning of an economy and can influence various economic factors such as inflation, interest rates, and economic growth.

Fractional reserve banking is based on the concept that not all bank deposits are withdrawn at the same time. Banks are required to hold a certain percentage of their deposits as reserves, which is determined by the reserve requirement set by the central bank. The reserve requirement is typically a fraction of the total deposits held by the bank.

Let’s take a closer look at the process of money creation by commercial banks:

1. Deposit Creation: When a customer deposits money into a bank, the bank adds that amount to its reserves. The bank is then able to lend out a portion of these reserves while keeping the required reserves as per the reserve requirement.
2. Lending Process: When a bank lends money to a borrower, it does not need to physically withdraw the funds from its reserves. Instead, it creates a new deposit in the borrower’s account, effectively increasing the money supply. This newly created deposit is considered as money in the economy and can be spent or used by the borrower.
3. Multiple Deposit Creation: The borrower may choose to spend the newly deposited money by writing checks or using electronic transfers. If the recipient of the funds deposits it into another bank, the process of deposit creation can repeat. The recipient bank can lend out a portion of the newly deposited funds, creating additional deposits and expanding the money supply even further.
4. Reserve Requirement: While banks are required to maintain a certain percentage of their deposits as reserves, they have the flexibility to lend out the remaining portion. This leads to a multiplier effect, where the initial deposit can result in multiple rounds of lending and deposit creation, significantly increasing the money supply.

It is important to note that the total amount of money created by commercial banks is influenced by the reserve requirement set by the central bank. A lower reserve requirement allows banks to lend out a larger proportion of their deposits, leading to a higher money multiplier and greater money creation. Conversely, a higher reserve requirement reduces the ability of banks to create money.

The process of money creation by commercial banks has both benefits and potential risks:

Benefits:

1. Credit Expansion: By creating additional money through lending, banks facilitate credit expansion, which enables individuals and businesses to access funds for investment, consumption, and economic activities.
2. Economic Growth: The availability of credit stimulates economic growth by funding productive ventures, job creation, and innovation. Money creation by commercial banks helps in meeting the demand for credit and fueling economic expansion.

Risks:

1. Inflation: When there is excessive money creation in the economy, it can lead to inflationary pressures. If the money supply grows faster than the production of goods and services, it can erode the purchasing power of money and cause prices to rise.
2. Financial Instability: If banks engage in excessive lending and the borrowers are unable to repay their loans, it can lead to financial instability. This was evident during the global financial crisis in 2008 when the collapse of mortgage-backed securities resulted in a severe banking crisis.
3. Systemic Risk: The interconnectedness of banks and their exposure to risks can create systemic risks. A failure of one bank can have a ripple effect, impacting other banks and the overall stability of the financial system.

To mitigate these risks, regulatory authorities, such as central banks, monitor and regulate the activities of commercial banks. They employ tools such as reserve requirements, capital adequacy ratios, and interest rate adjustments to manage the money supply and maintain stability in the financial system.

Score	Evaluation Criteria
Total score 100%	Meets all the criteria necessary for an A+ grade. Well formatted and instructions sufficiently followed. Well punctuated and grammar checked.
Above 90%	Ensures that all sections have been covered well, correct grammar, proofreads the work, answers all parts comprehensively, attentive to passive and active voice, follows professor’s classwork materials, easy to read, well punctuated, correctness, plagiarism-free
Above 75%	Meets most of the sections but has not checked for plagiarism. Partially meets the professor’s instructions, follows professor’s classwork materials, easy to read, well punctuated, correctness
Above 60%	Has not checked for plagiarism and has not proofread the project well. Out of context, can be cited for plagiarism and grammar mistakes and not correctly punctuated, fails to adhere to the professor’s classwork materials, easy to read, well punctuated, correctness
Above 45%	Instructions are not well articulated. Has plenty of grammar mistakes and does not meet the quality standards needed. Needs to be revised. Not well punctuated
Less than 40%	Poor quality work that requires work that requires to be revised entirely. Does not meet appropriate quality standards and cannot be submitted as it is to the professor for marking. Definition of a failed grade
Alternative url	www.crucialessay.com/orders/ordernow/www.collegepaper.us/orders/ordernow/

PLACE THE ORDER WITH US TODAY AND GET A PERFECT SCORE!!!