Credit creation is a process through which banks and other financial institutions generate credit or money supply in the economy. This process plays a vital role in the functioning of modern economies as it provides a mechanism for the allocation of resources to productive uses. In this essay, we will explore the credit creation process and its implications for the economy.
Credit creation process can be explained by the concept of fractional reserve banking. Fractional reserve banking is a system where banks hold only a fraction of the deposits made by their customers as reserves and lend the rest out. Banks use the deposits they receive to create loans, which are then used to finance various economic activities.
The process of credit creation starts when a person or a business deposits money in a bank. This deposit creates a liability for the bank, as it has to repay the depositor on demand. However, banks do not keep all the deposited money as reserves. They only keep a fraction of it, which is known as the reserve ratio. The reserve ratio is set by the central bank and varies from country to country.
For example, if the reserve ratio is 10%, then for every $100 deposited in a bank, the bank can lend out $90. The $10 that is held back as reserves is used to meet any withdrawals that may be made by depositors.
Once the bank has the deposited funds, it can use them to create credit. Banks create credit by making loans to individuals or businesses. When a loan is made, the bank credits the borrower’s account with the loan amount. The borrower can then use this credit to make purchases, pay bills, or invest in new projects.
The creation of credit by banks has a multiplier effect on the money supply in the economy. When the borrower uses the loan to make a purchase, the seller of the goods or services deposits the money in their own bank account. This deposit becomes a liability for the seller’s bank, which can then create credit and make new loans. This process continues, with each new loan creating more credit, and the money supply in the economy expanding.
The multiplier effect of credit creation can be calculated using the money multiplier formula. The money multiplier formula is:
Money multiplier = 1 / Reserve ratio
For example, if the reserve ratio is 10%, the money multiplier would be 1/0.1 = 10. This means that for every $1 deposited in the bank, the bank can create up to $10 in new loans.
The credit creation process is not without its risks. Banks create credit based on the assumption that borrowers will repay their loans with interest. However, there is always a risk that some borrowers may default on their loans, leading to losses for the bank. To mitigate this risk, banks use various techniques such as credit scoring, collateral, and loan covenants.
Another risk associated with credit creation is inflation. When banks create too much credit, it can lead to an increase in the money supply and inflation. Central banks use various tools such as interest rates, reserve requirements, and open market operations to control the amount of credit created by banks and manage inflation.