Explain in your own words the process by which banks “create” money.

The process by which the banks make create money is based on their ability to advance money to their customers (Burgi, 1994). Creation of money is not the actual printing of the money; it is the accounting process in which money lent out is credited on the bank’s books. The loans advanced are a liability from the bank. The actual money that the bank is literally working with, the float, is much less than the money that reflects on the accounts (Burgi, 1994).

Let’s take an example that person A deposits $1000, in a bank account with bank M. person B comes and borrows $500 at a 10% interest repayment rate, this means that $550 will be credited on the banks accounts. Person C comes and borrows $300 at 10% interest repayment rate, the bank will credit $330 to their account. The accounts will look something like this:

Credit

person A 1000 1000

Person B 550

Person C 330

Total 1880

The ban according to their books they have $1880 but practically they only have $200 left from the initial money deposited by person A.

Discuss the impact of that ability to create money on the economy during an inflationary gap, as well as during a recessionary gap. Considering the higher rates of unemployment and the likelihood of lower prices during a recessionary gap, do banks with their lending policies, contribute to a recovery back to potential output, or hinder that recovery? Why do you believe your answer to be correct? What about during an inflationary gap?

During a recessionary gap there are high levels of unemployment and a decrease in the average price level. This means that there isn’t enough money circulating in the economy and this means there is a decrease in aggregate demand and supply (Arnold, 2013). In order to increase the level of employment, there should be an increase in the money created by the banks in order to increase the amount of loans advanced to people. This will increase the level of investment and increase the aggregate supply due to increase in loans and increase aggregate demand because there will be more money circulating the economy. This will lead to an increase in the average price and will attract even more production and supply of commodities. Banks will aid in the recovery process.

The above answer is true because it confirms the Philips curve that is based on the assumption that in order to decrease unemployment by 1%, there must be a 3% increase in the level of inflation and the reverse is also true (Arnold, 2013). This is because more money decreases unemployment but increases the average price level.

During an inflationary gap the average prices of commodities are relatively high and the currency is usually devalued. Inflation is usually as a result of increase in the quantity of money that is circulating in the economy (Arnold, 2013). So when the banks continue to create more and more money during a period when there is inflation, then the inflationary gap will continue to increase and the economy becomes unstable. In order to curb inflation and to bring back the economy to stability where markets can clear, the banks should reduce the loans they advance to their clients by decreasing the money creation process.

References

Burgi Ed, (1994), Money Creation: The Great Confidence Trick, Orthodox Print Press, New York

Arnold, A. Roger, (2013), Economics (Arnold) 11th Edition, Prentice Hall Print, New Jersey