Money Creation by Banking System

The Logic of Money Creation

Banks do not simply act as intermediaries that take deposits and then lend them out. They actually create new money in the process. The textbook explains this using a simple story, similar to the one about Lala (which you may recall from earlier in the chapter). The key insight is that banks can lend money because they know that not all depositors will come to withdraw their money at the same time. This is the fundamental principle of fractional reserve banking.

When a bank gives a loan, it does not hand over a pile of cash from its vault. Instead, it opens a new deposit account in the borrower's name. The borrower can then write cheques or use a debit card against this new deposit. The total money supply in the economy therefore increases: it is now the sum of the original deposits plus this new deposit (plus any currency in circulation).

A Fictional Balance Sheet

To see this clearly, the textbook constructs a fictional balance sheet for a single bank in a country. A balance sheet is a snapshot of a firm's financial position at a given point in time. It records two things:

• Assets: What the firm owns or what others owe to it.
• Liabilities: What the firm owes to others.

By accounting convention, assets are listed on the left side and liabilities on the right side. The fundamental accounting identity is that the two sides must always balance:

If assets exceed liabilities, the difference is recorded on the liabilities side as Net Worth (or owner's equity). So the full identity is:

Assets of a Bank

For a bank, its assets are not just physical things like buildings and furniture. The most important assets are:

1. Loans: When a bank gives a loan of, say, ₹100 to a person, that loan becomes the bank's claim on that person for ₹100. It is an asset because the bank can expect to receive that money back (with interest).
2. Reserves: These are deposits that commercial banks keep with the central bank (the Reserve Bank of India, or RBI) plus the cash they hold in their own vaults. Reserves are partly held as cash and partly as financial instruments like bonds and treasury bills issued by the RBI. Think of reserves as the bank's own deposit with the central bank — just as your deposit with a commercial bank is your asset, a commercial bank's deposit with the RBI is its asset.

So, for a bank:

Liabilities of a Bank

The main liability of a bank is the deposits that people and firms have placed with it. These deposits are the bank's debt — it owes this money to its depositors and must return it on demand.

The Balance Sheet in Action

Let us put this together with a simple numerical example. Suppose the only bank in the country starts with no deposits and no loans. Then a person deposits ₹100 in cash. The bank's balance sheet changes as follows:

• Assets: Reserves increase by ₹100 (the cash it now holds).
• Liabilities: Deposits increase by ₹100 (the amount it owes to the depositor).

The balance sheet balances: Assets (₹100) = Liabilities (₹100).

Now, the bank decides to lend. It knows that the depositor is unlikely to withdraw all ₹100 immediately. So it can safely lend out a portion of this deposit. Suppose it lends ₹90 to a borrower. The bank does not give the borrower ₹90 in cash. Instead, it opens a new deposit account for the borrower with ₹90. The balance sheet now looks like this:

| Item | Amount (₹) |

| :--- | :--- | …