September 08, 2019 Sunday
Bedtime Story
How Commercial Banks Create Money
Now if you are left dazzled with the
mechanism of creation of money by the central banks secondary to the deficit
spending by the governments there is something else to further blow your mind.
We saw and understood how governments and
central banks work hand-in-gloves in the creation of money when the government
overspends and borrows.
In the act of borrowing money is created de
novo.
Besides the central bank the commercial
banks are involved too in the process of money creation whose modus operandi is
even more dazzling than those of central banks.
Unknown to most of you perhaps the one
single greatest service or the function of commercial banks is the credit
creation.
Credit is the stuff around which the entire
world of economics, finance and banking revolves.
While the word ‘credit’ technically means
trust of any means for deferred payment in practice it is synonymous with
money.
Commercial banks deploy a gimmick that is
known as fractional reserve wherein in the usual process of accepting deposits
from customers and lending loans to borrowers the banks retain with them only a
fraction of the money that the depositors have left with them.
Banks usually hold these reserves either as
cash with them or as balances in the bank accounts.
How much money the commercial banks are
supposed to keep in reserve is determined by the central banks of each country.
Now the commercial banks keep their
reserves far below their deposit liabilities – deposit liability being all the
money that people or companies have deposited with the bank and which at some
point of time or other they are going to ask back with their interest.
Banks take this chance of keeping low
reserves for two reasons.
One is that they take it for granted (or consider
it unlikely) that not all the depositors are going to demand back their
deposits at the same time (this assumption gets thrown out of the windows during
the times of economic crises when people develop low faith in banking system, panic
herd mentality sets in for cash withdrawal and the dreaded bank run sets in).
Second, the commercial banks also consider
it likely that most depositors are going to withdraw only a part of their
deposits with most of the times leaving the majority of their savings to grow.
The amount that is the difference between
the deposit liability and the reserve is given out on loans or credit which the
borrower has to refund with interest.
In banking and finance such loans that are
given out at interest are considered to be asset and thus by giving loan commercial
banks are increasing the money supply not only in their own accounts but in the
economy as well.
This thus is the second mechanism of money
creation on the assumption that all loans are secure.
Stay tuned to the voice of an
average story storytelling chimpanzee or login at http://panarrans.blogspot.com
Good night Mon Ami and my fellow cousin ape.
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Another great educator and a teacher that I am aware of is
Professor Subhashish Chattopadhyay in Bangalore, India.
While I narrate stories, Professor Subhashish an electronic
engineer and a former professor at BARC, does and teaches real mathematics and
physics.
He started the participation of Indian students at the
International Physics Olympiad.
Do visit him here:
All his books can be downloaded for free through this link:
For edutainment and English education of your children, I
recommend this large collection of Halloween Songs for Kids:
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