Buying government securities: When a commercial bank buys government bonds, the effect is substantially the same as that of lending - new money is created.

To illustrate let us take the same hypothetical example of Bank A, the balance sheet of which stands as under:

Balance Sheet of Bank A

For simplicity, let us assume that the RBI recognizes government bonds as 'acceptable' unencumbered securities which can be held by commercial banks to satisfy the liquid assets requirement. This means that the Bank A can now keep its required liquid assets in government bonds rather than in cash.

Bank A increases its reserves with the RBI to Rs.8,00,000 by depositing the cash with it and holdings of liquid assets. Now suppose that, instead of making a loan, the bank buys Rs.7,55,000 worth of government securities from a bond broker. The bank receives the high interest-bearing bonds which appear on its balance sheet as the assets 'securities' and gives the broker an increase in its demand deposits by the same amount. The balance sheet, then, would appear as follows:

Balance Sheet of Bank A

The important point to note from the above balance sheet is that demand deposits, that is, the supply of money, have been increased by a total of Rs.7,55,000. The bank has accepted government bonds - which are not money - and gives the securities broker an increase in demand deposits - which is money. Thus, by buying government bonds, the bank has created money.

When the securities broker draws and clears the cheque of Rs.7,55,000 against the Bank A, the demand deposits and reserves of Bank A with RBI will reduce by Rs.7,55,000. Its reserves with RBI will be just meeting its 15 percent cash reserve requirement but it will have Rs.7,55,000 worth of government securities, an excess amount to meet its liquid assets requirement. Its balance sheet would show as follows:

Balance Sheet of Bank A