Answer to Question #49537 in Macroeconomics for Rima

Question

Suppose Mr. Y deposits AED 100,000 into a one-year Certificate of Deposit at 5% interest. The Central Bank sets the reserve ratio for the banks at 10%.

a) Illustrate how the banks create money with the help of given information.
(Show first 5 steps)
b) Calculate the total money creation in the economy with the help of formula.

Answer 1

a) In economics, money creation is the process by which the money supply of a country or a monetary region (such as the Eurozone) is increased. A central bank may introduce new money into the economy (termed 'expansionary monetary policy', or 'money printing' by detractors) by purchasing financial assets or lending money to financial institutions. Commercial bank lending also creates money under the form of demand deposits. When banks had sizable reserve requirements (freezing an important percentage of their deposits in mandatory reserves at the central bank) it was said that the process multiplied this base money through fractional reserve banking.
b) The total money creation in the economy will be: 100,000/0.1 = AED 1,000,000 according to the multiplier effect.