how banks create money

John deposited some amount of money in the bank. Let's see how his money travels.

To the deposited amount of money, the bank gives John a small amount of interest (1%).

The bank gives out loans at a higher interest rate i.e. 5% to other people using the same deposit.

Profit made by bank = Incoming Interest - Interest Expense

5% - 1% = 4% income Expense Profit

To keep John's money safe so that he can take it out whenever he wants, his bank uses a Fractional Reserve Banking system.

It states that the bank needs to hold a fraction of deposit in cash and can loan out the rest.

So if John deposited Rs.10,000 then, the bank keeps 10% of it i.e. Rs.1,000 in cash and loans out the left Rs.9,000. In total the money supply equals to Rs.19,000.

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