Analysis of Money Creation by Banks: Macroeconomics Assignment

This assignment delves into the process of money creation by banks, a crucial concept in macroeconomics. It begins by challenging the common misconception that banks simply lend out deposits, instead emphasizing their role in actively creating money through the lending process. The assignment uses a hypothetical bank scenario to illustrate how initial deposits lead to increased money supply (M1) via loans, demand deposits, and the fractional reserve system. It explains how banks, acting as financial intermediaries, contribute to the expansion of the money supply. The assignment also highlights the role of the Federal Reserve and the impact of lending on the overall economy, citing relevant academic sources to support its analysis. The paper explains the process of money creation through loans and the impact on the economy.

Running head: MACROECONOMICS
Macroeconomics
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1MACROECONOMICS
Table of Contents
Money creation by banks.................................................................................................................2
References........................................................................................................................................3

2MACROECONOMICS
Money creation by banks
The bank manager’s statement that “she does not create money but simply makes loans to
her clients’ is not right. In an economy, banks are responsible for creating money. In fact, money
and banks are interconnected. The banking system eventually creates money by the process of
loan disbursement. This can be understood by considering the example of a hypothetical bank.
Suppose, the bank has a total deposit of $10 million. Now if federal reserve ratio is $1 million
(that is 10 percent of total deposit), then the bank is left with $9 million for making loans. By
loaning $9 million and charging an interest, the bank is able to pay interest payment to its
depositors and earn an interest income (Schumpeter, 2016). Banks are thus not only act as a
place of deposit but also function as a financial intermediary between borrowers and savers.
Whenever banks make loan out of the deposits, it increases money supply M1. M1 is defined as
the simplest form of money supply that includes demand deposits which is widely accepted as a
medium of exchange for purchasing goods and services. The initial $10 million deposit now
increases money supply to $19 million, $10 million as the demand deposit and $9 million in the
hand of first borrower. When this bank gives loan to a second bank, it again keeps 0.9 million as
reserve to the Fed and rest of $8.1 million is given as loans. The process goes on contributing to
money creation in the economy (Di Muzio & Noble, 2017). This explains how lending by banks
increases money supply of the economy.

3MACROECONOMICS
References
Di Muzio, T., & Noble, L. (2017). The coming revolution in political economy: money creation,
Mankiw and misguided macroeconomics. Real-World Economics Review, 80, 85-108.
Schumpeter, J. A. (2016). Bank credit and the “creation” of deposits. Accounting, Economics
and Law: A Convivium, 6(2), 151-159.