How Commercial Banks Create Money, Essay Example

Money creation is one of the most prominent levers of influencing money supply, inflation, and interest rates on the market. Therefore, other than the Federal Bank Reserve and government central banks, commercial banks are key subjects in money creation. Commercial banks implement money creation through operations with public loans. They are capable of directly influencing the supply of money on the market, which is why government central banks and the Federal Bank Reserve exist in the first place. Since checking deposits make the largest portion of the total money supply, banks may increase or decrease the money supply through checking deposits by lending activities. Through means of legislation, for the purpose of governmental control of the country’s money supply, banks may only lend the amount of money that equals the amount of the remaining reserves; these reserves are called excess reserves. Since banks earn their profits from charging interest rates on the given loans, their goal is to increase the distributed loans by using excess reserves, which were partly created by deposits of their clients. Meanwhile, the Federal Bank Reserve sets a required reserve ratio, which limits the amount of given loans. The required reserve ratio is a fraction of a deposit which a bank cannot redistribute as a new loan. The required reserve ratio is one of the key governmental tools in fighting inflation. This ratio may change with monetary policies of the country; however as of 2006 the required reserve ratio of the United States was 10%. Thus, commercial banks receive deposits from their clients, they use these deposits to give out new loans. For example, in the case of US’s required reserve ratio, a bank receives a deposit from a client X worth $10 000, it has the right to lend another client Y $9 000 for a specific charge; client Y can in advance deposit the borrowed money to another bank, which can further issue a loan of $ 8 100 to client Z. Therefore, technically there have appeared $10 000 + $9 000 + $8 100 = $27 100 on the money market. Correspondingly commercial banks created money on legal grounds, making the government not the single issuer of money.