Banks create money whenever they:
A: accept a deposit.
B: receive monthly payments on their loans.
C: receive interest on existing loans.
D: lend excess reserves to a borrower.
What have you learned from your text?
Text suggest both choices A and D are true.
I vote for D.
Thank you! Was unclear due to the suggestion that choice A is the first step leading to choice D.
You're welcome.
In this case, the correct answer is D: lend excess reserves to a borrower. Banks have the ability to create money through a process called "fractional reserve banking." Let me explain how this works:
1. Banks accept deposits (option A), which are considered liabilities. When you deposit money into a bank account, it becomes an asset for the bank, but they are liable to return that money to you upon your request.
2. Banks are also involved in lending activities, where they provide loans to borrowers. When a person or business takes out a loan, the bank credits their account with the borrowed amount. Now, this loan is considered an asset for the bank because they expect to receive interest payments (option C) on the loan.
3. Here's where the money creation process comes into play. When a bank lends money, they don't need to have the exact amount in reserves. They are only required to maintain a certain fraction of their deposits as reserves (this fraction varies by country and regulations).
4. So, let's say a bank has $100 in deposits, and the reserve requirement is 10%. They need to keep $10 in reserves and can lend out the remaining $90. Here's the interesting part: when they lend $90 to a borrower (option D), that money is credited to the borrower's account as a loan. Although the bank's liabilities (deposits) have not changed, they have created an asset (the loan) out of thin air.
By lending out money that is not backed by reserves, banks effectively create new money in the economy. This process is known as money creation through fractional reserve banking. It is worth noting that money creation by banks is regulated to ensure stability in the financial system.