How Banks create money out of thin air?

Banks make money "out of thin air" through a process called Fractional reserve banking, which allows them to create new money primarily via lending. Here's how it works in detail:

Fractional Reserve Banking

Indian banks are mandated by the Reserve Bank of India (RBI) to keep only a fraction of their customer deposits as reserves—called the Cash Reserve Ratio (CRR). For example, if the CRR is 4%, banks have to keep ₹4 as reserves for every ₹100 deposited. The remaining ₹96 is available to be lent out.

In the fractional reserve banking system, the ₹96 that a bank lends out after keeping ₹4 in reserves is re-lent multiple times through a process called the money multiplier effect. Here's a detailed explanation of how this happens:

Step 1: Initial Deposit and Reserve Requirement

• Suppose a customer deposits ₹100 in Bank A.

• Bank A must keep ₹4 as reserves (if the Cash Reserve Ratio (CRR) is 4%).

• That leaves ₹96 available for lending.

Step 2: First Loan and Spending

• Bank A lends ₹96 to a borrower.

• The borrower uses this ₹96 to make a purchase, and the recipient of this payment deposits the ₹96 in Bank B.

Step 3: Bank B’s Reserves and Lending

• Bank B receives the ₹96 deposit.

• It must keep 4% of ₹96, which is ₹3.84, as reserves.

• Bank B can lend out the remaining ₹92.16 to another borrower.

Step 4: Cycle Repeats

• The ₹92.16 loaned out by Bank B will be spent and deposited in Bank C.

• Bank C keeps 4% of ₹92.16 (₹3.69) as reserves.

• It lends out ₹88.47.

• This process continues, with each bank lending out the maximum amount possible after keeping the required reserve.

Mathematical Explanation: Money Multiplier

The money multiplier formula is:

Money Multiplier=1CRRMoney Multiplier=CRR1

So, with a CRR of 4% (0.04):

Money Multiplier=10.04=25Money Multiplier=0.041=25

This means the original deposit of ₹100 can theoretically create up to ₹2,500 in total deposits, considering repeated lending.

How ₹96 Gets Re-lent:

The initial ₹96 loan creates a new deposit, which becomes the basis for the next round of loans, less the reserves. This cycle repeats:

96+92.16+88.47+85.03+⋯=2400 (approx.)96+92.16+88.47+85.03+⋯=2400 (approx.)

Each time, the lent amount shrinks slightly due to the reserve requirement but continues enough times to significantly increase the money supply.

Real-World Factors

• Borrowers may withdraw cash instead of depositing again, reducing re-lending.

• Banks might hold excess reserves.

• Not all loaned money returns immediately as deposits.

• Some loans may default.

Despite these factors, the system allows banks to expand the money supply multiple times over the original deposit, which is how the ₹96 is lent many times in sequence.

This detailed re-lending cycle forms the core mechanism of how fractional reserve banking expands money supply "out of thin air" in India and globally.

Money Creation via Loans

When a bank grants a loan, it does not physically hand over cash but instead credits the borrower's account with a new deposit, effectively creating new money that did not previously exist. This loan amount increases the total money supply in the economy. When the borrower spends this money, the recipients deposit it in their banks, which again hold a fraction as reserves and lend out the rest. This cycle repeats multiple times, amplifying the money supply—a process known as multiple deposit creation.

Interest: The Bank’s Profit Engine

Although banks create money through loans, they charge interest on these loans. This interest is how banks generate real income and profit. The money created through loans is not free—it must be paid back with interest, which is the bank's revenue source. Thus, while the principal amount is created digitally "out of thin air," the interest repayments generate continuous revenue streams for banks.

Regulatory Oversight and Risks

The RBI regulates reserve requirements and lending practices to maintain financial stability, but concerns exist about banks lending far more than their actual reserves, which could lead to risks if too many loan defaults occur. The fractional reserve system relies on trust and the continuous flow of deposits and loans.

Indian banks create money "out of thin air" through the fractional reserve banking system by lending more than the cash they physically hold. This creates new deposits and expands the money supply in cycles. Banks earn income by charging interest on these loans, thus monetizing the newly created money.

This system is the backbone of modern banking and underpins economic growth, but it requires careful regulation and risk management to function sustainably.