How commercial banks create money, Macroeconomics

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Q. How commercial banks create money?

Commercial banks clearly can't influence the amount of currency in economy or monetary base because they aren't allowed to print money. They can, though, influence the money supply through second component of the money supply - the deposits. A bank would increase the money supply simply by lending money to a customer. Similarly when a loan is amortized orrepaid, money supply decreases.

It may sound odd that money supply increases by 1 million the same instant a bank agrees to lend this amount. Bank has created money however no wealth (please keep in mind that these are different notions). The bank has simply converted one asset (cash) into another (promise of repayment) whereas there is no change in the individual's net wealth. Though after the loan, there is an extra one million available for immediate consumption. It makes not any difference if the borrower keeps the money in her account or withdraws them in form of currency.

If for instance, borrower uses the money to buy an apartment, funds are transferred to the seller of the apartment. This won't affect the money supply - now it's the seller of the apartment who has a million available for consumption. If seller uses the funds to repay the loan he got when he bought apartment, money supply will again decrease.


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