Money Creation - Money Creation Through The Fractional Reserve System

Money Creation Through The Fractional Reserve System

Through fractional-reserve banking, the modern banking system expands the money supply of a country beyond the amount initially created by the central bank. There are two types of money in a fractional-reserve banking system, currency originally issued by the central bank, and bank deposits at commercial banks:

1. central bank money (all money created by the central bank regardless of its form, e.g. banknotes, coins, electronic money)
2. commercial bank money (money created in the banking system through borrowing and lending) - sometimes referred to as checkbook money

When a commercial bank loan is extended, new commercial bank money is created. As a loan is paid back, more commercial bank money disappears from existence. Since loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remains relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple is determined by the reserve ratio or other financial ratios (primarily the capital adequacy ratio that limits the overall credit creation of a bank) set by the relevant banking regulators in the jurisdiction.