Credit creation

Credit creation refers to the process by which banks and financial institutions generate new money and credit in the economy through the extension of loans, advances, and other forms of credit to borrowers.
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Updated on Jun 7, 2024
Reading time 4 minutes

Key Takeaways

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  • Credit creation involves the expansion of the money supply and credit through the issuance of loans and the creation of deposit liabilities by banks.
  • Banks create credit by making loans to borrowers, who in turn use the borrowed funds to make purchases, investments, or repay existing debts, thereby circulating money within the economy.
  • While credit creation contributes to economic growth and prosperity, excessive or imprudent lending practices can lead to credit bubbles, financial instability, and systemic risks.

What is Credit Creation?

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Credit creation refers to the process by which banks and financial institutions increase the money supply and inject liquidity into the economy by extending credit to borrowers. When banks issue loans or make advances to individuals, businesses, or governments, they effectively create new money in the form of deposit liabilities, which can be used for spending, investment, or debt repayment.

Importance of Credit Creation

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  • Economic Expansion: Credit creation fuels economic activity by providing individuals and businesses with access to funds for consumption, investment, and production, thereby stimulating demand, generating income, and fostering growth and development.
  • Monetary Policy Transmission: The expansion of credit influences monetary policy transmission mechanisms by affecting interest rates, money supply growth, and aggregate demand, thereby influencing inflation, employment, and output levels.
  • Financial Intermediation: Banks and financial institutions play a vital role in allocating capital and resources efficiently by intermediating between savers and borrowers, channeling funds from surplus units to deficit units, and supporting investment and entrepreneurship.

How Credit Creation Works

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  1. Loan Origination: Banks create credit by originating loans and advances to borrowers based on their creditworthiness, collateral, and lending criteria. This process involves evaluating credit risks, assessing borrower profiles, and determining loan terms and conditions.
  2. Deposit Creation: When banks extend credit to borrowers, they simultaneously create new deposit liabilities in the borrowers’ accounts, which serve as a source of funds for spending, investment, or withdrawal. This deposit creation expands the money supply and increases liquidity in the economy.
  3. Money Multiplier Effect: The process of credit creation sets off a multiplier effect on the money supply, as the newly created deposits are re-deposited, re-lent, and re-spent within the banking system, leading to further rounds of credit expansion and money creation.

Examples of Credit Creation

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  • Consumer Loans: Banks create credit by issuing consumer loans, such as mortgages, auto loans, personal loans, and credit card loans, enabling individuals to finance purchases, home ownership, education, or other expenses.
  • Business Financing: Banks provide credit to businesses through lines of credit, term loans, trade finance facilities, and other financing arrangements, supporting capital investments, working capital needs, and business expansion initiatives.
  • Government Borrowing: Banks extend credit to governments through the purchase of government securities, treasury bills, and bonds, financing public expenditures, infrastructure projects, and budget deficits.

Real World Application

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  • Mortgage Lending: Banks create credit by originating mortgage loans to homebuyers, which are then securitized, sold in secondary markets, and used to fund additional lending activities, contributing to the growth of the housing market and the broader economy.
  • Corporate Finance: Banks extend credit to corporations for capital investment projects, mergers and acquisitions, working capital needs, and debt refinancing, supporting corporate growth, job creation, and economic expansion.
  • Central Bank Operations: Central banks influence credit creation and money supply dynamics through open market operations, reserve requirements, and discount rate adjustments, implementing monetary policy objectives and managing macroeconomic stability.

Credit creation is a fundamental driver of economic growth, financial intermediation, and monetary policy transmission, playing a pivotal role in the functioning of modern economies. By providing individuals, businesses, and governments with access to credit and liquidity, banks and financial institutions support investment, consumption, and production, stimulating economic activity and fostering prosperity. However, effective regulation, prudent lending practices, and risk management are essential to ensure that credit creation serves as a catalyst for sustainable development and financial stability, rather than fueling speculative bubbles, excessive debt accumulation, or systemic risks.


Sources & references

Arti

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Arti is a specialized AI Financial Assistant at Invezz, created to support the editorial team. He leverages both AI and the Invezz.com knowledge base, understands over 100,000 Invezz related data points, has read every piece of research, news and guidance we\'ve ever produced, and is trained to never make up new...