How Banks Create Money

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GROUP 1

NAMES: MEHTA DHRUVI DEVANG- 640502

         CHELLANI AARTI NARAIN- 642046

        NGARE MELISSA WANGARI- 637249

        KARANJA REUBEN WANJIHIA- 636869

        MOHAMED ABDIHAMID ABDIAZIZ- 641278

ASSIGNMENT: HOW BANKS CREATE MONEY

LECTURER: PROF SAN LIO

SEMESTER:  FALL 2015

Contents

INTRODUCTION        

HOW BANKS CONTROL THE SUPPLY OF MONEY        

Discount rate        

Change reserve rate        

Open market operation        

HOW BANKS CREATE MONEY        

Open market operation        

Fractional reserve banking        

Bank charges        

Auction of assets        

Charges for Vaults        

Interests        

Offering consultation and financial advice        

REFERENCES        

INTRODUCTION

Money is a current medium of exchange. It is used to buy commodities and run day to day activities and transactions. There are continuous ongoing discussions on how banks create money.  According to research “money creation” is defined as a process by which money supply of a country is increased.

Central banks may introduce new money into the country by “money printing” or they would buy financial assets or also lend money to financial institutions. Commercial banks also create money by the process of lending money to the public. There are several ways in which central banks can control/ influence the supply of money in the economy

HOW BANKS CONTROL THE SUPPLY OF MONEY

There are 3 ways in which central bank influences the supply of money in the market:

Discount rate

This is the interest rate set aside by the Central banks for lending money to other banks. The banks usually set a rate at which they will lend the money. This way they can control the amount of money supply in the market. If they set higher rate there would be less money supply in the market

Change reserve rate

This is basically deciding the rate at which the deposits must be held. It is Requirements regarding the amount of funds that banks must hold in reserve against deposits made by their customers. This money must be in the bank's vaults or at the closest Federal Reserve Bank. It is also known as "required reserves”.

Open market operation

This is Fed’s primary tool for fine-tuning the money supply. This is where central bank buys and sells financial assets such as treasury bills, government bonds, or foreign currencies from private parties. Purchase of these assets result in money entering the market circulation, while selling the bonds removes money from the market circulation. This way the central bank could control the money supply in the market, because if there is too much money supply, then there would be less commodities to purchase and hence this may cause inflation.

HOW BANKS CREATE MONEY

There are a few ways in which banks create money.

1. Open market operation

The first way is by open market operation. As we explained earlier open market operation is just a basic way where the central bank buys and sells government securities and bonds. When they central bank buys the bonds they increase the money supply by the amount of the purchase and also increase the amount of reserves in the banking system that are available and multiple deposit creation.

When the central banks sells securities on the open market, reserves are withdrawn from the banking system which decreases the total amount of excess reserves available to use as a guideline for lending. This triggers a multiple contraction of the money supply and checking deposit destruction.

1. Fractional reserve banking

This is a simple and the most important concepts the bank uses. Here the banks hold a fraction of money which was available from the deposits made by its customers and lends the rest of the money out to the borrowers. When the bank’s loan this money they create new money supply.

Required Reserves –– Fraction of customers' deposits that banks are required by to keep on hand in their vault or with the Federal Reserve Bank.

Excess Reserves –– Fraction of customers' deposits beyond required reserves which form the basis for bank loans.

To explain this concept in more details, we will be using an example;

Example1:

Suppose John deposits $100 into Bank 1. This $100 has created a new money supply in Bank 1. Now Bank 1 decides to use 10% as their required reserves rate. This means the bank decides to hold $10 as their required reserve incase John comes back to withdraw some money and decides to lend the rest $90 (known as the excess reserves) to another client/ borrower. So Bank 1 then approves the loan of $90 to Mary. Mary then has the control of what she wants to do with the $90 she just borrowed from Bank 1. Say that Mary writes a cheque of $90 to Ted, and Ted deposits $90 which he just received in Bank 2. This means that Bank 2 has created a new money supply of $90. Now again Bank 2 will decide to hold $9 as required reserves and loan out $81 (Excess reserves) to another client. This process continues to happen from one bank to another. This will then eventually lead to money creation and result in increased money supply for the banks.