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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

In a simple model of the banking system, a bank holds deposits and keeps a fixed fraction as reserves. Which statement best describes how commercial banks create money?

Commercial banks create money by lending: the loan proceeds are credited to the borrower's account as a new deposit. Deposits form part of broad money, so lending expands the money supply, subject to reserve requirements and the willingness of banks and borrowers to transact.

  1. AThey print additional notes whenever depositors request cash
  2. BWhen banks lend, the loan proceeds are credited as new deposits, expanding the money supplyCorrect
  3. CThey convert existing deposits into government bonds, which raises broad money
  4. DThey transfer reserves to the central bank, which then issues new currency
  5. They lend only the exact amount of deposits previously received, leaving the money supply unchanged

Explanation

When a bank makes a loan, it credits the borrower's account, creating a new deposit. Deposits are part of broad money, so the money supply grows. Option 4 describes a no-creation view that ignores that loans become deposits redeposited in the system.

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