Question

According to the Bank of England, money is created when a bank makes a loan and destroyed with the loan is repaid.  Explain this statement.10 marks

Answer 1

Answer:
As stated above taking out a new loan creates the money and loan repayment destroys the money. Taking an instance of credit card flow, when consumer uses the credit card to spend money to his daily needs throughout the month. Every transaction that he does via credit card increases the outstanding loan against him in credit card balance sheet which gets deposited in various merchants balance sheet from whom consumer have purchased the items. If consumer pays his outstanding dues at the end of the month in full, his bank would reduce the amount of deposits from his personal account by the value equal to the credit card outstanding bill, destroying all the newly created money.
Hence banks making loan to be utilized by the customer and then repaying it back are the most significant way of creating and destroying money in modern financial systems.

Even though banks generate money from the interest they earn while lending money to the customer they cannot keep on lending without regulations and restrictions which are governed by competitive banking system and central bank regulations. Banks are limited by how much they can lend to stay profitable. The retail and corporates customers who takes loan from the bank generates money for the bank in the form of interest which gets destroyed the moment they repay the loan in full.

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