Question

Ravi deposits ₹ 50,000 in his savings account in a commercial bank. The bank loans a part of this money to give loans to another customer. This process is repeated with other deposits and borrowers.

Answer 1

This situation describes how money creation works in a fractional reserve banking system. When Ravi deposits ₹ 50,000 into the bank, the bank doesn’t keep the entire deposit. Instead, it is required to keep only a fraction of this amount as reserves (a requirement set by the central bank). The remaining amount, which is not held as reserves, is loaned out to other customers. The borrower of this loan will likely deposit the loaned amount in another bank, and that bank will also keep a portion as reserves and lend out the rest. This process continues, with each new deposit enabling the creation of additional money in the form of loans. This is the basis of the multiplier effect, where the total money supply increases by a multiple of the original deposit. For example, if the reserve requirement is 10%, then from Ravi’s ₹ 50,000, the bank will keep ₹ 5,000 as reserves and lend out ₹ 45,000. The next bank receiving the ₹ 45,000 will keep ₹ 4,500 as reserves and lend out ₹ 40,500, and so on. This process is crucial to the functioning of the economy because it allows the money supply to expand and facilitates economic growth through credit.