If someone wants to borrow INR 1,000 for a day and promises to return INR 10,000 the next day, you might not believe him, as magic only happens in Harry Potter movies. But if that someone is a bank, you better take it seriously. The article below explains how this magic works.
Suppose there were no banks in the city you live in and the first bank opened today. You went to the bank and deposited INR 1000. As per Government regulations, banks need to set aside at least 10% of the deposit amount as reserve and rest can be lent out. It is easy to understand why Government would want such a rule. If banks lend out the entire deposit amount, it will have none left to meet depositor’s withdrawal requirement. Thus, banks retain some part of the money to meet their liquidity requirements, before lending out the remaining amount. We will learn more about this percentage requirement in future articles.
Let’s come back to our example. You deposited INR 1000 with the bank, bank retained INR 100 (10% of 1000) and loaned out the rest to a company seeking a loan of INR 900 to fund its capital requirement. Company utilised this amount to buy tools and machinery, from a capital supplier, for its new plant. This supplier, after receiving the money from company, went to the same bank again and deposited INR 900. In this roundabout way, money again came back to the bank in the form of deposit, but it was 10% lesser than the original deposit amount. The below chain explains this process.
Now again as per Government rule, bank will have to retain 10% of the deposit and can lend rest of the amount. This time bank will retain INR 90 (10% of INR 900) and will lend out only INR 810. Let’s suppose bank lent INR 810 to a farmer, to buy seeds and fertilizers. The farmer bought these from a fertilizer manufacturing company. The company, after receiving payment from the farmer, returns to the bank to deposit the money. Thus money again came back to the bank in the form of deposit, but it was 10% lesser than the deposit amount of INR 900. The process can be seen in the following flow chart.
This process will keep on repeating. Every time bank receives a deposit it will retain 10% of the deposit amount and lend out the balance.Sum of all these deposit amounts (INR 1000+ INR 900 + INR 810 …) will add up to INR 10,000. As discussed in the beginning, if banks say they will convert INR 1000 to INR 10,000, you better take it seriously. This shows how small amount of money injected into the economy results in economic activity worth many folds larger than the amount injected.
Let’s learn more about money and the role played by central bank in the whole process.