How do banks create money through fractional reserve banking?

• A. By issuing loans and creating deposits; loans create new deposits, expanding the money supply beyond base reserves.
• B. By printing banknotes.
• C. By increasing capital stock.
• D. By adjusting exchange rates.

Answer: (A)

Money is created by banks when they issue loans. When a loan is approved, the bank credits the borrower’s account with the loan amount, so the borrower now has a new deposit. That deposit is new money in the economy, even though it didn’t come from existing cash, because the bank’s balance sheet now shows an asset (the loan) and a liability (the new deposit). Banks must hold only a fraction of deposits as reserves, but that requirement doesn’t stop them from creating additional deposits with new loans. As the borrower spends and those funds are deposited elsewhere, the process can repeat, expanding the broad money supply through the money multiplier. Printing banknotes is the central bank’s job, not the banks’ loan-driven creation. Increasing capital stock or adjusting exchange rates do not create new money in this way.