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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

In a simple model of the banking system, which of the following best describes how commercial banks create broad money?

Banks create broad money by lending a portion of deposits while keeping reserves. The loan proceeds are spent and redeposited within the banking system, generating further deposits, so total deposits grow by a multiple of the initial deposit.

  1. AThey print notes whenever customers request cash withdrawals
  2. BThey lend part of the deposits they hold, and the loans are redeposited in the banking system, creating new depositsCorrect
  3. CThey transfer gold reserves to the central bank in exchange for deposits
  4. DThey buy foreign currency from households and destroy the rupee deposits
  5. They hold all deposits as reserves so total deposits cannot exceed the original amount

Explanation

When a bank lends, the borrower's spending becomes a deposit at some bank, which can lend again after holding reserves. This repeated lending and redepositing expands total deposits. Option E describes a 100% reserve system, where no multiplication occurs.

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