Money Supply Growth Is Related to Credit Creation

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The Answer is Financial institutions are in business to make a profit. They do this by lending out as much as they can of the funds placed with them by depositors. If they were to lend out too much they would not have enough to repay customers who want to draw money from their accounts, and the public would lose confidence in the financial system. Through experience in the market financial intermediaries usually know how much they must keep as liquid funds for this purpose (although the global financial crisis shows this is not always the case). When extra cash deposits are made in financial intermediaries, they hold back a proportion of these according to their liquidity ratio. The remainder they lend out. When people borrowing the money spend it, these funds will end up back in the financial system in the financial accounts of firms who received the money. This enables the same process to be repeated and will continue until the original extra cash deposited is all required to be held back as liquid assets to support the new higher lending. The process of credit creation is known as the 'bank multiplier'.

Money Supply Growth Is Related to Credit Creation

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