The correct option is 2 only
Explanation
The banking system creates money through a process known as Fractional Reserve Banking. Under this system, banks are required to hold only a fraction of their total deposits as reserves (Cash Reserve Ratio) to meet potential withdrawals, allowing them to lend the remaining amount. This lending process leads to credit creation, which multiplies the initial deposit into a larger amount of money in the economy.
Statement-wise Analysis:
- Statement 1 is Incorrect: Banks operate on the statistical premise (Law of Large Numbers) that not all depositors will withdraw their funds simultaneously. This confidence allows banks to keep only a small portion of deposits as liquid cash (reserves) and lend the rest to borrowers, thereby facilitating credit creation.
- Statement 2 is Correct: When a bank lends money, it does not deduct the amount from its capital reserves (which represent the bank's own equity or accumulated profits). Instead, the bank typically credits the loan amount to the borrower's account, effectively creating a new demand deposit. This process expands the bank's balance sheet by creating a new asset (the loan) and a corresponding new liability (the deposit), rather than reducing existing capital.
- Statement 3 is Incorrect: The total money supply in the economy increases, rather than decreases, by the amount of the new deposit created. When a bank lends, it creates new purchasing power (credit) that functions as money. This addition to the circulation increases the aggregate money supply (M3).
Key Takeaway:
Commercial banks create money by lending out excess reserves, relying on the fact that withdrawals are a fraction of total deposits. This process creates secondary deposits, which increases the total money supply in the economy via the Money Multiplier effect.