Banks do not create money out of thin air. In fact, there is nothing magical or incomprehensible about the creation of bank deposits. At every  step one can watch what is happening to the bank accounts. Usually a bank cannot lend more then what it receives from its depositors. But, though multiplication of loans and advances, the bank can multiply its deposits. The process is called “multiple expansion of bank deposits.

In a modern society, bank deposits are created in two ways. A bank can create deposits passively against the cash or cheques it receives from its customers. Such deposits are known as primary deposits. Primary deposits cause an increase in both the banks’ assets as well as in their liabilities. In the creation of such deposits, the banks play a passive role in determining the size of the deposits; the customer’s decision to deposit cash constitutes the real and active force in the creation of primary deposits. Creation f primary deposits, however, merely transforms the currency money into deposit money and leaves the stock of money available to the society unchanged.

Another way the banks can create deposits actively is by creating claims against themselves and in favor of borrowers or sellers of assets or securities acquired by deposits arise from granting of loans or purchase of securities or assets by the bank. The size of derivative demand deposits is determined by the lending and investing favor of those the whom they grant loans or from whom they buy securities. Since derivative deposit is actively created by the bank, it increases the community’s ownership of demand deposits without involving any decrease in people’s holding of currency. Thus, it increases the total stock of money available to the community. The creation of derivative deposits is identical with what is commonly known as creation of credit by the commercial banks.

We shall now explain this process of deposit multiplication. We will repeat this process in. First, we will consider a simple model of an economy in which only one bank operates, and all money transactions take place only through the agency of this single bank. We will call this model a ‘single-bank economy’, and examine how multiple expansion of bank deposits takes place in this type of economy. In our second stage, we will consider a more realistic ‘multiple-bank economy’, and examine how multiple expansion of deposits takes place in this type of economy.

To explain the process of multiple expansion of deposits in a single-bank economy, we will proceed with the help of a simple illustration, reserving a more technical treatment of the subject for a later part of the section.

Let us suppose, the bank in our economy-for sake of brevity we all it Bank X- receives a public deposit of Rs. 100. The minimum  reserve requirement is being put at 10 per cent of the total deposits, i.e., the Bank X need keep with itself a cash reserve equal to Rs. 10 only to meet any demands arising out of its liabilities to its depositors. The bank has an excess reserve of Rs. 90. The sum can be extended in the from of loans and advances to the borrowers. loans and advances are extended more usually in one of the following forms:

(a)    Bank may grant overdraft facilities to its depositors;
(b)    Bank may discount bills of exchange; or
(c)    Bank may open a new deposit in its books of account in favour of the borrower, crediting the amount of loan in the deposit account of the borrow, i.e., the bank raises its liabilities at the same time as it is adding to its assets.

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