Answer to Question #217206 in Macroeconomics for camillus

Question

Using an appropriate hypothetical example, describe how commercial banks “creates
and multiplies money” in an economy

Answer 1

Solution:

Commercial banks create money in the form of bank deposits by clients. New money is then generated by the commercial banks in form of loans issued from the deposits made which they charge and earn interest. These loans include business loans, personal loans, car loans, and mortgages. Therefore, when banks extend loans to their clients, they create money by crediting their client’s accounts.

Commercial banks can then multiply money in an economy by either issuing loans or investing in excess reserves hence increasing money supply, which is utilized multi-fold. This is because commercial banks generate numerous credits which are more than their cash reserves contributing to the increase in money supply in the economy.

For example, when you take out a mortgage to buy property, a commercial bank will not necessarily issue you with physical cash but rather it will credit your bank account with a bank deposit the size of the mortgage, thus creating new money.