HOW BANKS CREATE MONEY AND CREDIT WHEN THEY MAKE LOAN.

All modern banks create money, and they create credit (the obligation to pay money in the future) as well. Exactly how does this occur? First, remember that money is simply a medium of exchange- an object or item that is readily accepted by seller in payment for the goods and services they offer. In most industrialized economies, checks are still the principal means of paying for goods and services. When and how do banks create checkbook forms of money? It happens in two ways, first, when a customer is granted a loan (credit), he or she will sign a promissory note and receive, in turn, a banks demand deposit (checking account). The customers promissory note is not money; it cannot be used to buy goods and services. But a banks demand deposit is money and can readily be spending almost anywhere. Thus, in granting loans (creating credit), banks create money as well by setting up a spendable deposit in the name of the borrower. Second, the entire system of banks also creates money as the deposits generated by lending flow from bank to bank. By law, each bank must set aside only a fractional reserve behind each deposit it receives and the remaining excess reserves can be loaned out. As customers spend the proceeds of their loans, these funds flow out to other banks, giving them deposits from which to create loans (credit) as well. While no single bank can lend out more than its excess reserves, the entire banking system can create a multiple volume of deposit money through bank lending (credit creation). If there were no leakages from the banking system (such as customers withdrawing cash from their checking accounts or unutilized reserves), an initial deposit of Tk. 1 of new reserves in the baking system would result in Amount of new money creation= 1/RR x Amount of new reserves. Where RR is the reserves requirement ratio (or percentage of cash banks themselves must keep in reserve) imposed either by the central bank or by bankers themselves. The term 1/RR is often called the money multiplier. If, for example, the reserves requirement ration is 10%, then each Taka of new reserves placed in the baking system would result in new money creation in the amount: 1/0.10 x Tk. 1 = 10 x Tk. 1 = Tk. 10 If leakages exits in the form of the public withdrawing cash (pocket money) from their checking accounts and placing some portion of their incoming funds non-spendable savings instruments, then these leakages (L) from the banking system would reduce the money multiplier to 1/(RR=L). If L has a value of 0.20 and RR is 0.10, then the amount of new money creation for each Tk.1 of new reserves placed in the banking system would be: 1/ 0.10 + 0.20 x Tk. 1 = 3.33 x Tk. 1 = Tk. 3.33 Given all the leakages from money flows that occur in the real world, most authorities believes that the real-world deposit multiplier the banking system can generate is probably somewhat less than 2. The banking systems capacity to create money is one reason banks are so closely regulated by government.