Alomar_111_MCP 1

Money Creation Process

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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

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A L

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Since cash is part of bank’s reserves, the (100) becomes reserves now

A L

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If the required reserve ratio = 10%, then reserves can be divided into:

Required reserves = (10%)(100)=KD10

Excess reserves = 100-10= KD90

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A L

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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)

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A L

RR 10 Checkable D 100ER 0Loans 90

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

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A L

RR 19 Checkable D1 100ER 81 Checkable D2 90Loans 90 190 190

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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

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A LRR 19 Checkable D1 100ER 0 Checkable D2 90Loans 171 190 190

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This process will continue… We started with (KD100) but total

deposits increased by more than the initial (KD100)

This is called “money creation”

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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)