Annex 2C


substantially refined and modified by the Keynesian and monetarist schools, but this is
beyond the scope of this manual). Nevertheless, there can be no doubt that money supply is,
according to the principles expressed in above identity equation, a major determinant of the
prevailing price levels and of the rate of inflation. This fact provides the rationale for efforts
to restrict the money supply under adjustment.

3. Money Creation through Credit Expansion within the Banking Sector

Money deposits on checking accounts with a bank, reserve requirements, and the interaction
of lending and payments within the banking system are the key elements in credit expansion
and money creation within the banking sector. This is illustrated by the following example.

We assume that an initial deposit of $ 1,000 is made on a checking account. The bank keeps a
certain percentage (we assume 10 %) of the deposited amount as cash reserve and uses the
rest for new loans or investments (e.g. in treasury bonds). The process of money creation
starts as soon as payments resulting from the additional loans or investments (in our case:
$ 900) are credited to checking accounts with other banks. The second round bank(s) will
keep 10 % of the deposits ($ 90) as cash reserve, too, and use the rest ($ 810) for new loans or
investments. These new loans or investments will, again, lead to increased deposits with
other banks in a third round. The process will continue ad infinitum with, depending on the
reserve requirements, decreasing additional amounts per step. At the end of the process, the
originally deposited amount of $ 1,000 will have induced a 10-fold increase in new deposits.
or in other words will have "created" additional money of $ 9,000 and led to an increase in
total money supply of$ 10,000. The following table illustrates this process.

Table 2C: Illustration of the Process of Money Creation through the Banking System

 Position of bank New deposits New loans/investments New reserves
 _________ $ $ $
 Original bank 1,000.00 900.00 100.00
 2nd round bank(s) 900.00 810.00 90.00
 3rd round bank(s) 810.00 729.00 81.00
 4th round bank(s) 729.00 656.10 72.90



 Total after all rounds 10,000.00 9,000.00 1,000.00

The ratio of increased bank money to increased reserves is called the money-supply
multiplier and is calculated using the following formula:
 dM = dCD x (')
 where dM stands for total additional money supply, dCD for the initial additional cash
 deposit, and r for the share of the reserve requirements. In our example above, this gives :
 10,000 = 1,000 x ( -' )
 The above formula indicates the maximum theoretical amount of additional money created
 within the banking system on the basis of an initial cash deposit. In practice, there are various
 factors which restrict credit and money expansion to a smaller amount.


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