Question

Elaborate the process of Credit Creation using a suitable numerical example.

Hint:

Remember — banks create credit by lending out deposits while keeping a fraction as reserves, multiplying money supply in the economy.

Answer 1

Commercial banks expand the money supply through credit creation, which originates from primary deposits. This is enabled by the fractional reserve system, whereby banks retain a portion of deposits as reserves and disburse the remainder as loans.Numerical Example:Consider an initial bank deposit of ₹ 1,000 with a Legal Reserve Ratio (LRR) of 20%.
The bank retains ₹ 200 (20% of ₹ 1,000) as its cash reserve.
It lends out ₹ 800 to borrowers.
This lent amount of ₹ 800 re-enters the banking system as a subsequent deposit.
From this new deposit, 20% (₹ 160) is held as reserve, and ₹ 640 is lent out.
This iterative process continues.Total Credit Creation:The total deposits created can be calculated using the formula:\[\text{Total Deposits Created} = \frac{\text{Initial Deposit}}{\text{Cash Reserve Ratio (CRR)}}\]\[= \frac{1000}{0.20} = ₹ 5,000\]Therefore, an initial deposit of ₹ 1,000 results in a total of ₹ 5,000 in deposits within the banking system.