Credit creation is the way commercial banks increase the total amount of money in an economy. They do this by lending out a portion of the money deposited by customers.

When a bank grants a loan, it does not just hand over cash; instead, it creates a new bank deposit for the person borrowing the money. This action immediately increases the total money supply.

This process is guided by two main factors:

• Reserve ratio: The specific percentage of total deposits that banks are legally required to keep in their vaults or at the central bank, rather than lending it out.
• Credit multiplier: The cumulative effect of this lending process across the entire banking system, which turns a small initial deposit into a much larger total amount of money.