Creation of Money by Banking System
We can now discuss how the banking system of country can "Create" money.
Banks create money by creating deposits, There are two kinds of deposits, actual deposits and created deposits. When a man puts a certain sum of money into his account, we call it an actual deposit. When a bank gives a loan to a person, an account is opened in his name and he is credited with the amount of the loan. Suppose for example that X obtains a loans of Rs. 5000. The bank will open an account in his name with Rs. 5000 to his credit. X can draw cheques on this account. This is a "Created" deposit. [A loan may of course be given in other ways also, eg., by paying out the cash immediately. Usually, however, loans appear in the form of created deposits as shown above.
It is sometimes said the every loan creates a deposit. In the example given above, X borrows Rs. 5000. If he takes the entire money out in the form of cash immediately, there is no deposit in the lending bank. But X will use the money for some purpose. Suppose that he pays it to Y from whom he has purchased goods. Y will put the money in some bank or the men to whom Y pays the money will do so. Hence, if in the country concerned, banking habits are well developed the money lent out by a bank will find its way into some deposit account in the banking system. We can therefore say that every loan creates a deposit.
It is now possible to explain how the banking system of a country can create money. It is a well known fact that depositors do not withdraw the whole of their money at a time. If a bank has total deposit of Rs. 1 crore, only about 10% of it will be withdrawn on a particular day. In the mean time other deposits will come. Hence, the bank can provide for all withdrawals if it keeps about 10% of the total deposits in the form of cash. The remainder of the deposits will not be withdrawn and can be lent out to other [ The percentage of deposits, which ensures safety, differs from country to country and from time to time. In some countries it is 16%. The bankers must be a good judge of the habits of his customers.] The percentage of deposits which a bank keeps in the form of cash is called the cash-reserve.
Let us suppose that a bank, called the "P" Bank, receive a cash deposit of Rs. 1000. Following the usual banking practice the P Bank will keep 10% of the money (ie., Rs 100) in hand and lend out the remainder (RS. 900). The money lent out will in due course reach some bank or banks. Lets us suppose that the whole of it goes to "Q" bank. This bank will now keep 10% of Rs. 900 (ie., Rs. 90) in hand and lend out the remainder (RS. 810). This money, Rs. 810, will now be deposited in some other bank, which is let us suppose, the "R" bank will thereupon keep 10% of Rs.810 (ie., Rs. 81) in hand and lend out the remainder (RS. 729). The loans and deposits will go on until the final deposit becomes too small.
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