The process of deposit and loan (credit) creation by banks is explained below. In order to understand this process, let us discuss a story.
Once there was a goldsmith named LaLa in a village. In this village people used gold and other precious metals in order to buy goods and services. For the gold deposit with LaLa, they were receiving a paper receipts by paying a small fee. Slowly the paper receipt began to circulate as money. And the paper receipt was accepted as a medium of exchange.
Now, let us suppose that LaLa had 100 kgs of gold deposits and he has issued receipts corresponding to 100 kgs of gold. At this timeRamu comes to LaLa and asks for a loan of 25 kgs of gold. Can LaLa give the loan? The 100 kgs of gold with him already has claimants. However, LaLa could decide that everyone with gold deposits will not come to withdraw their deposits at the same time and so he may as well give the loan to Ramu and charge him for it. If LaLa gives the loan of 25kgs of gold, Ramu could also pay Ali with these 25 kgs of gold and Ali could keep the 25 kgs of gold with LaLa in return for a paper receipt. In effect, the paper receipts, acting as money, would have risen to 125 kgs now. It means that LaLa has created money out of thin air
The modern banking system works precisely the way LaLa behaves in this example.
