How banks create money, let’s examine what happens when someone decides to deposit currency in a bank. Consider the example of Mr X, a miser, who keeps a box full of cash under his bed. Suppose Mr X realizes that it would be safer, as well as more convenient, to deposit that cash in the bank and to use his debit card when shopping. Assume that he deposits Rs1,000 into a checkable account at First Bank (A). First Bank (A) credits Mr. X with Rs1,000 in his account, so the economy’s checkable bank deposits rise by Rs1,000. Meanwhile, Mr.X cash goes into the vault, raising First Bank (A) reserves by Rs1,000 as well. This initial transaction has no effect on the money supply. Currency in circulation, part of the money supply, falls by Rs1,000; checkable bank deposits, also part of the money supply, rise by the same amount. But this is not the end of the story because First Bank (A) can now lend out part of Mr.X deposit. Assume that it holds 10% of Mr.X deposit—Rs100—in reserves and lends the rest out in cash to Mr.X neighbor, Mr. Y. First Bank (A) deposits remain unchanged, and so does the value of its assets. But the composition of its assets changes: by making the loan, it reduces its reserves by Rs 900, so that they are only Rs100 larger than they were before Mr. X made his deposit. In the place of the Rs 900 reduction in reserves, the bank has acquired an IOU, its Rs 900 cash loan to Mr. Y. So by putting Rs 900 of Mr.X cash back into circulation by lending it to Mr. Y, First Bank (A) has, in fact, increased the money supply. That is, the sum of currency in circulation and checkable bank deposits has risen by Rs 900 compared to what it had been when Mr. X’s cash was still under his bed. Although Mr. X is still the owner of Rs 1,000, now in the form of a checkable deposit, Mr. Y has the use of Rs 900 in cash from her borrowings. And this may not be the end of the story. Suppose that Mr. Y uses her cash to buy a television and a DVD player from Acme Merchandise. What does Ram, the store’s owner, do with the cash? If he holds on to it, the money supply doesn’t increase any further. But suppose he deposits the Rs 900 into a checkable bank deposit—say, at Second Bank. Second Bank, in turn, will keep only part of that deposit in reserves, lending out the rest, creating still more money. Assume that Second Bank, like First Bank (A), keeps 10% of any bank deposit in reserves and lends out the rest. Then it will keep Rs 90 in reserves and lend out Rs 810 of Ram deposit to another borrower, further increasing the money supply. At first the money supply consists only of Mr. X’s Rs 1,000. After he deposits the cash into a checkable bank deposit and the bank makes a loan, the money supply rises to Rs1,900. After the second deposit and the second loan, the money supply rises to Rs 2,710. And the process will, of course, continue from there. (Although we have considered the case in which Mr. X places his cash in a checkable bank deposit, the results would be the same if he put it into any type of near-money.) This process of money creation may sound familiar.
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