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Money Creation Process

Money Creation Process. A person opens a checking account at bank (A) with (KD100) in cash. This rises the liability of the bank by (100) If the bank keeps the (100) in cash, this rises the assets side of the balance sheet. A L.

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Money Creation Process

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  1. Money Creation Process Alomar_111_MCP

  2. A person opens a checking account at bank (A) with (KD100) in cash. • This rises the liability of the bank by (100) • If the bank keeps the (100) in cash, this rises the assets side of the balance sheet Alomar_111_MCP

  3. A L Alomar_111_MCP

  4. Since cash is part of bank’s reserves, the (100) becomes reserves now A L Alomar_111_MCP

  5. If the required reserve ratio = 10%, then reserves can be divided into: • Required reserves = (10%)(100)=KD10 • Excess reserves = 100-10= KD90 Alomar_111_MCP

  6. A L Alomar_111_MCP

  7. Since excess reserves earn no interest. Bank (A) may choose to make a loan worth of (90). (why not lend the 100)? • The bank make profits now: • (interest paid on loan) – (interest paid on deposits) Alomar_111_MCP

  8. A L RR 10 Checkable D 100 ER 0 Loans 90 Alomar_111_MCP

  9. Assume now that your friend who borrowed the (KD90), went to bank (A) and opened a checking account Alomar_111_MCP

  10. A L RR 19 Checkable D1 100 ER 81 Checkable D2 90 Loans 90 190 190 Alomar_111_MCP

  11. Total deposits = KD190 • Since excess reserves earn no interest, bank (A) will make a loan of the (81) to another person. • Excess reserves = 0 • Total loans = KD171 Alomar_111_MCP

  12. A L RR 19 Checkable D1 100 ER 0 Checkable D2 90 Loans 171 190 190 Alomar_111_MCP

  13. This process will continue… • We started with (KD100) but total deposits increased by more than the initial (KD100) • This is called “money creation” Alomar_111_MCP

  14. Deposit multiplier = 1/rrr = 1/0.10=10 • Thus, the total amount of deposits bank (A) can create = (10)(100) = KD1000 • Total loans = 1000 – 100 = 900 (total deposits – total required reserve) Alomar_111_MCP

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