Money creation refers to the process by which the money supply in the economy changes. The process involves a money multiplier, where every rupiah of new base money will multiply.
How does money creation work
The central bank requires commercial banks to keep a portion of customer deposits as reserves. The proportion of deposits held as reserves is known as the reserve requirement ratio.
Reserve requirement ratio = Reserve requirement / Total deposit
Let’s say the central bank sets a reserve requirement ratio of 5%. Because the economy is sluggish, the central bank carries out an open market operation by buying government securities. The aim is to increase the money supply to stimulate economic growth.
For example, the central bank buys Rp100 of government securities from a bank. Money goes to the bank. After setting aside Rp5 as reserves (Rp100 x 5%), the bank lends the remainder, amounting to Rp95, to a debtor. The debtor uses the money, for example, to recruit a professional consultant.
From the money received, the consultant deposits the money of Rp95 to the second bank. And, the bank then lends Rp90.25 to its customers and holds Rp4.75 (5% x Rp95) as a reserve.
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The customer uses the money to buy goods from a seller. Then, the seller deposits cash in the third bank. The bank sets aside Rp4.51 (5% x Rp90.25) as a reserve and makes a loan for the remaining (Rp85,74).
The cycle continues, and money circulates many times in the economy with thinning numbers. In the end, the total amount of money in the economy will increase several times (20 times). Thus, the initial increase in the monetary base of Rp100 multiplies to Rp 2,000.
That multiple is known as a money multiplier and is calculated by the following formula:
Money multiplier = 1 / Reserve requirement ratio = 1/5% = 20