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How Does Money Increase Through Credit Creation By Commercial Banks?

Investor education does not limit only to understanding the financial ratios pertaining to profitability or growth of the companies. Investors must be aware of the macro environment factors that drive the financial markets. Among many things that a retail investors needs to know about investing, one of the key things he must understand is money creation.

Everyone knows that commercial banks borrow and lend funds to earn a margin from their activities. While banks do have their own funds or capital to lend to borrowers, they do not always lend their own funds. Most of the lending is done out of the deposits they receive from their customers. Commercial banks typically run by borrowing funds from customers (deposits) for lower interest rates and then lending it to its customers for higher rates. Now instead of the bank arranging for its own funds or capital it is allowed to lend the deposits it receives from the customers. Most of the economies have fractional reserve banking system. This means that the banks need to retain only a certain portion of their deposits in readily available form and can lend rest of the deposits. Whenever a loan is sanctioned based on these deposits, funds are not physically transferred to loan account but an entry is made in books of the banks. When the loan amount is transferred into a new deposit account, the bank can again sanction loan against it without actually any physical currency money with the bank. The process of re-deposit and loan issuance creates credit. For example, Mr. A deposits USD 1000 with ABCBank and Mr. B borrows USD 800 loan from the same bank. Mr. B creates a new account in PQRBank to deposit his USD 800 loan and this bank gets to sanction another USD 700 to Mr. C out of Mr. B's deposits. This way every new credit sanctioned creates money without printing of new hard currency and the money in circulation increases.

This creation of money out of credit by commercial banks increases the money supply in the system and drives growth in economy. However, when money is pumped into the system without real growth in the economy, it leads to inflation and devaluation of currency. However, the central banks and governing authorities of the countries use many monetary and fiscal policies to ensure financial stability in the country. Recent concerns of public and economists who oppose the concept of money creation through debt, suggest that the process cannot be applied for long as credit creation leads to infinite money supply.

Since the value of any currency is based on the demand and supply, it becomes really crucial to understand how much money is in circulation, in terms of that currency. To understand this we can use statistics published on regular basis by the central banks of each country. Currency in circulation or, M0 as most of the central banks call, is the actually currency printed by the government of a country either held in bank vaults or given out in circulation. M2 or quasi money includes M0 and deposits held in the banks, while M3 includes all the M2 and all money market funds and repo funds. When credit growth is faster than the economic growth of the country, then money loses its value due to excess supply. A prudent financial advisor would help the investors in understanding the trends in the macro economic environment, and help them in making the best of the information in hand.