CMA Foundation · Fundamentals of Business Economics and Management · Money and Banking
A bank's primary function of 'creating credit' arises mainly because:
Credit creation occurs because banks lend out a portion of deposits while keeping a fractional reserve, and the loaned money returns to the banking system as new deposits. This repeated process multiplies deposits. Printing notes and interest spreads do not explain credit creation.
- Ait prints currency notes against its gold reserves
- Bit lends out a part of its deposits, and the loans return to the banking system as fresh depositsCorrect
- Cit charges a higher rate on loans than on deposits
- Dit deposits all collected funds with the central bank
Explanation
Banks keep only a fraction of deposits as reserves and lend the rest. These loans are spent and redeposited in banks, creating new deposits and multiplying credit. Printing notes is a central bank function, and the interest spread explains profit, not credit creation.
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