How Commercial Banks Create Money and Measures Used by Central Banks

This study explores how commercial banks create money through loans and assets, and discusses the measures used by central banks to limit money creation. It highlights the role of central banks in maintaining economic stability.

Microeconomic and Macroeconomic

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
MAIN BODY...................................................................................................................................1
a) Discuss how commercial banks create money........................................................................1
b) Discuss the measures used by the Central Banks to limit the ability to create money...........2
CONCLUSION................................................................................................................................3
REFERENCES................................................................................................................................4

INTRODUCTION
Macro- economics in turn is referred to as one of the branch of economics which is highly
concerned with the various range of economic factors like national productivity, interest rate, etc.
This study will highlight on how the commercial banks tend to create money. Moreover, this
study also tends to evaluate the measures which has been used by the Central Banks in order to
limit the ability to create money.
MAIN BODY
a) Discuss how commercial banks create money.
A commercial bank is referred to as a financial institution which in turn accepts deposits,
offered loans, of financial services and financial products such as saving accounts to small
businesses and individuals, certificate of deposits (Michell, 2017). Commercial banks tends to
make money by giving loans and also earning interest from the loans which has been provided to
the individuals. The types of loan which are given to the people by commercial banks mainly
comprises of auto loans, mortgages, lease, personal loans, business loans, etc. However, serious
customer deposits associated with money market accounts, certificate of deposits, saving
accounts, checking accounts, et cetera helps in providing banks with the capital to give loans to
people. Customers who in turn deposit some money into such accounts in turn tends to get
interest by the bank. Moreover, the interest rate which has been paid to the individuals from
whom they borrow money is less when compared with the rate which has been charged on
money lent to the customers. This difference in interest in turn is considered to be profit for the
banks (Murau, 2017). The degree of money which has been earned by the commercial bank is
usually determined by spread between the interest bank earns on loans issued to the customers
and the interest it pays on the deposit. However, commercial banks are in turn allowed to create
money by effectively allowing various claims on the asset deposits with bank. Commercial banks
also tends to create money by buying assets. However, extending the loan of the customers in
turn is considered to be as very beneficial for the bank as it helps them in creating huge degree of
money by crediting the account of the customers.
Commercial banks in turn tends to create money by granting new set of loans and in the
form of bank deposits (Wójcik-Mazur, and Szajt, 2015). The commercial bank in turn tends to
loan money to the customers and this way it also tends to charge the interest which in turn is
higher than what the bank in turn pays to the people who deposit there money with the bank. The
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spread difference between the amount the lent and the amount collected in turn tends to represent
high degree of revenue for the specific bank. Moreover, the interest which has been earned on
the various loan books which helps commercial bank in generating revenue by effectively
charging the customer fees for various other banking services and mortgages (Hanson and et.al.,
2015). The commercial banks tends to charge fees for various financial banking products and
checking accounts. This way it will help bank in generating high degree of revenue for the
commercial bank. There are various set of loan products which in turn tends to include fees in
addition to the various set of interest rate which has been charged to the customers. Moreover,
the origination fee of around 0.5%- 1% on the mortgage loan in turn is considered to be as one of
the effective way in order to create money for the commercial bank. This fees is usually earned
over the life of mortgage loan which is considered to be as effective way to create money for the
commercial bank.
b) Discuss the measures used by the Central Banks to limit the ability to create money.
Central bank tends to play one of the most crucial role in banking and monetary system of
the specific economy. They in turn are highly responsible for the maintenance of economic
stability and also the financial sovereignty within the specific country. They in turn tends to
largely focus on the issuance of the currency, controlling of the interest rates and also regulating
the money supply (Poast, 2015). Central banks tends to limit the supply of the money by
influencing the various set of factors such as interest rate, setting up of the reserve requirement
of the bank, printing money, etc. in turn are considered to be as effective tools which in turn
helps central bank in controlling the supply of the money. Buying and selling of the government
debts in the formation of short term government bonds. The central bank also tends to highly
focus on creating open market operations and also quantitative easing which in turn helps in
involving buying and selling up of the government securities and bonds (How Central Banks
Control the Supply of Money, 2020). Central bank is highly responsible for pumping money into
the economy in order to keep it growing and healthy. However, the quantity of money which has
to be circulated within the economy tends to affect both macro and micro economic trends. It is
very important for the central bank to control the quantity of the money which has to be
circulated within the economy in order to attain economic objectives (Bech, and Malkhozov,
2016). The central banks mend it commercial banks to keep some degree of money as reserve
which is considered to be an effective measure in order to limit the ability to create money.
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When the central bank wants to decrease the quantity of money in the economy circulation, it
tends to sell government securities to commercial institutions. However, quantitative easing in
turn is considered to be as one of the most effective measure which in turn usually helps in
limiting the ability to create money into the economy which eventually leads to attainment of
various economic goals and objectives (Mehrotra and Yetman, 2015).
The Central Bank tends to decrease the amount of money printing which helps in reducing
the flow of money within the economy. Influencing the interest rate for the various loans is
considered to be as the effective measure which helps in limiting the money within the economy.
High degree of interest rate in turn tend to decrease borrowing, and this states that the quantity of
money in circulation also decreases. Controlling and decreasing the supply of money within the
economy helps in propping up the value of the money and it also useful in stopping inflation
(Wójcik-Mazur, and Szajt, 2015). Increasing the demand for the loans and increasing the
economy in turn is considered to be as one of the most effective measure which in turn helps in
reducing the flow of money within the economy.
CONCLUSION
From the study it has been concluded that, Commercial banks tends to make money by
giving loans and also earning interest from the loans which has been provided to the individuals.
Commercial banks also tends to create money by buying assets, charging the origination fee and
providing various range of commercial products. It has been concluded that, Central bank is
largely focus on the issuance of the currency, controlling of the interest rates and also regulating
the money supply. Quantitative easing and engaging in the open market operations in turn they
help in limiting the ability to create money into the economy.
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REFERENCES
Books and Journals
Bech, M.L. and Malkhozov, A., 2016. How have central banks implemented negative policy
rates?. BIS Quarterly Review March.
Hanson, S.G and et.al., 2015. Banks as patient fixed-income investors. Journal of Financial
Economics, 117(3), pp.449-469.
Mehrotra, A.N. and Yetman, J., 2015. Financial inclusion-issues for central banks. BIS Quarterly
Review March.
Michell, J., 2017. Do shadow banks create money?‘Financialisation’and the monetary
circuit. Metroeconomica, 68(2), pp.354-377.
Murau, S., 2017. Shadow money and the public money supply: the impact of the 2007–2009
financial crisis on the monetary system. Review of International Political Economy, 24(5),
pp.802-838.
Poast, P., 2015. Central banks at war. International Organization, 69(1), pp.63-95.
Wójcik-Mazur, A. and Szajt, M., 2015. Determinants of liquidity risk in commercial banks in the
European Union. Argumenta Oeconomica, 2(35), pp.25-48.
Online
How Central Banks Control the Supply of Money. 2020. [ONLINE]. Available through<
https://www.investopedia.com/articles/investing/053115/how-central-banks-control-supply-
money.asp>
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