How Loans Affect Money Creation and Destruction in the Banking System

When Loans Are Repaid At Commercial Banks

Commercial banks are financial intermediaries that accept deposits, make loans, and offer checking accounts. They play a crucial role in the money supply of an economy, as they can create or destroy money through their lending activities.

Money Creation by Commercial Banks

When a commercial bank makes a loan to a borrower, it does not lend out the money from its existing deposits. Instead, it creates new money by crediting the borrower’s account with the loan amount. This increases the bank’s assets (the loan) and liabilities (the deposit). The borrower can then withdraw the money or write checks on their account, which increases the money supply in the economy.

The process of money creation by commercial banks is limited by two factors: the reserve requirement and the demand for loans. The reserve requirement is the percentage of deposits that banks must keep as reserves, either as cash in their vaults or as deposits at the central bank. The reserve requirement acts as a safety cushion for banks to meet their depositors’ withdrawals and as a tool for the central bank to control the money supply. The demand for loans depends on the interest rate that banks charge and the creditworthiness of borrowers.

The money creation process can be illustrated by the concept of the deposit multiplier, which is the ratio of the change in total deposits to the change in reserves. The deposit multiplier is equal to 1 divided by the reserve requirement. For example, if the reserve requirement is 10%, then the deposit multiplier is 10. This means that for every $1 increase in reserves, the banking system can create $10 of new money through loans.

Money Destruction by Commercial Banks

When loans are repaid at commercial banks, the opposite process of money creation occurs. The repayment reduces the bank’s assets (the loan) and liabilities (the deposit). The borrower’s account is debited with the principal and interest payments, which decreases the money supply in the economy.

The process of money destruction by commercial banks is also limited by two factors: the reserve requirement and the demand for loans. The reserve requirement determines how much reserves the bank can free up by reducing its loans. The demand for loans determines how much of the freed-up reserves the bank can lend out again.

The money destruction process can be illustrated by the concept of the deposit multiplier, which works in reverse. For example, if the reserve requirement is 10%, then for every $1 decrease in reserves, the banking system can destroy $10 of existing money through loan repayments.

Commercial banks have a significant impact on the money supply of an economy, as they can create or destroy money through their lending activities. The process of money creation or destruction depends on two factors: the reserve requirement and the demand for loans. The central bank can influence these factors by changing the reserve requirement ratio or by conducting open market operations, which affect the availability and cost of reserves for banks. By doing so, the central bank can control the money supply and implement monetary policy.