Economics » Financial Institutions » Creation of Money and Monetary Policy

# The Creation of Money

## The Creation of Money

The creation of money by commercial banks reflects the view that by granting loans and advances, an initial deposit with a commercial bank can yield greater cumulative demand deposits in the entire commercial banking system. When a commercial bank advances a loan, it opens an account in the name of the customer creating a claim against itself and in favour of the customer (borrower). Note that the loan is made, not by physically handing over claims, but by creating a bookkeeping entry. The same procedure is followed by other banks – each keeping small cash in reserve and lending the remaining amount. The entire commercial banking system, thus, creates demand deposit money and the economy is reflated.

The maximum total demand deposit money (Mdep) that the entire commercial banking system will create given an initial deposit (A) and statutory cash reserve ratio (r) can be obtained using the formula:

Mdep = $$\cfrac{A}{R}$$ or $$\cfrac{1}{R}$$ x A ………………………………… (13.1)

In equation (13.1), the deposit multiplier (Kdep) is

Kdep = $$\cfrac{1}{R}$$ ……………………………………………….. (13.2)

According to equation (13.2), the deposit multiplier is the reciprocal of the cash reserve ratio maintained by the banking system. The higher the cash ratio, the lower the deposit multiplier and the lower the demand deposit expansion, and vice versa. Multiple demand-deposit expansion occurs when an initial cash deposit causes an expansion of the money supply by a multiple of the initial deposit. The assumptions underlying the process of deposit money creation are:

1. The banking system is comprised of many banks.
2. There is no cash leakage in the system.
3. The statutory cash reserve ratio (i.e. the percentage of the total deposit liabilities of the banks that they are legally required to keep with the Central Bank) is given.
4. All banks in the system are willing and able to make loans to the limit set by cash reserve requirements.
5. The initial deposit of a customer in his current account is given.

### Example:

Suppose a customer deposits ₦120 000 in a commercial bank, and the cash reserve ratio imposed by the Central Bank is 5 percent.

1. Calculate the deposit multiplier.
2. Determine the maximum amount of deposit money that can be created by the entire commercial banking system of the economy.

Solution

1. To obtain demand deposit multiplier Kdep
Kdep = $$\cfrac{1}{R}$$

= $$\cfrac{1}{0.05}$$

= 20

b. The maximum deposit money that can be created is Mdep

Mdep = $$\cfrac{A}{R}$$

where A = ₦120,000 (i.e. deposit)

= $$\cfrac{120,000}{0.05}$$

= ₦2.4 million