Loading the lesson
Loading the lesson
Search AllRounder.ai
Search the courses, subjects, tracks, games and features, or jump straight to a page.
Search the courses, subjects, tracks, games and features, or jump straight to a page.
Learn it your way
A short class with Sarah and her students. The other ways are under More.
Sign up free to listen. Transcripts are free to read.
Today, we're going to learn about the initial step in the credit creation process. When a customer deposits money into a bank, what do you think happens to that money?
I think the bank keeps the money safe.
That's correct! The bank keeps the money, but it doesn't just sit there. It gets recorded as part of the bank's total funds. Can anyone tell me what happens next with this deposit?
Isn't there a rule about how much money they have to keep?
Exactly! This is known as the reserve requirement. The bank must keep a portion of the deposit as a reserve. Remember, we can use the acronym 'R' for Reserve to help us remember this part.
What does the bank do with the rest of the money then?
Great question! The bank can lend out the excess reserves. This leads us to the next step in the credit creation process.
Now, let’s discuss the reserve requirement in more detail. Why do you think banks are required to keep a reserve?
So they can handle withdrawals, right?
That's right! Banks need to ensure they have enough funds to meet customer withdrawals. The reserve ratio is crucial. Can anyone tell me what it determines?
It determines how much money can be lent out!
Exactly! A lower reserve ratio allows banks to lend more, creating more credit. Can you think of a potential consequence if the reserve requirement is too high?
The economy could slow down because less money is available for loans.
Correct! High reserve requirements can limit credit flow, which slows down economic activity. This is an important point to remember.
Now we move to the next step: lending the excess reserves. When banks lend out money, what happens to it?
The borrowers will spend it.
Correct! And when they spend it, what's likely to happen next?
I think the borrowers deposit that money back in another bank.
Exactly! This creates a cycle where the money continues to circulate within the banking system. This process is called the money multiplier effect. Can anyone describe what the money multiplier is?
It’s how much money can be created from the initial deposit!
Excellent explanation! The money multiplier is determined by the reserve requirement. Let's summarize this process so we can move on.
The process by which commercial banks lend out deposits and create new money in the economy.
The percentage of deposits that must be held as reserves and not lent out, dictating the lending capacity of banks.
The potential expansion of the money supply based on bank lending activities affected by the reserve requirements.
If a customer deposits $10,000 in a bank with a reserve requirement of 10%, the bank must keep $1,000 but can lend out $9,000, which can eventually lead to a total of $90,000 in new loans if the process continues.
When borrowers use their loans to make purchases, the money they spend often gets redeposited into various banks, further enhancing the money creation process through additional lending.
When funds are in a bank, some they must retain, the rest they lend, to create money gain.
Imagine a town with one bank. Bob deposits $100. The bank keeps $10 and lends $90 to Alice, who buys goods. Those goods get sold, and the money returns to the bank. This cycle builds wealth for the whole town!
Think of R.E.L. - Reserve, Excess, Lending - to recall the steps in credit creation.
Remember LEAD: Lending, Excess reserves, Active banking, Deposit creation.
Term
What is credit creation?
Click to flip
Term
What does the reserve requirement dictate?
Click to flip
Term
What is the money multiplier?
Click to flip
The process by which banks lend out a portion of their deposits, leading to an increase in the money supply.
The percentage of deposits that banks are required to hold in reserve and not lend out.
The potential increase in the money supply that results from banks lending out their reserves.
In this section, we explore the process by which commercial banks create credit through their lending activities, highlighting the reserve requirements and the impact on the overall money supply.
This section delves into the mechanics of credit creation by commercial banks, detailing the steps involved from an initial deposit, reserve requirements, to the lending of excess reserves. It emphasizes the importance of the reserve ratio and its implications for the money supply in the economy.
Credit creation is a fundamental function of commercial banks, which allows them to stimulate economic growth by lending money. When a customer deposits money into a bank, the bank is required to maintain a fraction of this deposit as reserves, a requirement set by the central bank (known as the reserve requirement or reserve ratio). The process can be broken down into three main steps:
This cycle continues, showcasing how a simple deposit can lead to a significant increase in the total money supply within the economy. The extent of credit creation hinges primarily on the reserve requirement: a lower reserve ratio increases potential credit creation, while a higher ratio constrains it.