Question

“When initial deposits in the credit creation process remains same, the total amount of credit created rises as the value of money multiplier increases.” Defend or refute the above statement with the help of hypothetical numerical example. OR “Central Bank maintains reserves of all commercial banks and use to settle interbank claims.” Do you agree with the given statement? Give valid explanation in support of your answer.

Hint:

Higher money multiplier → more credit creation
Central bank = banker’s bank + clearing house

Answer 1

Step 1: Understanding the Concept:
Credit creation is the process by which commercial banks create money. The total credit created depends on the Money Multiplier ($k$), which is inversely related to the Legal Reserve Ratio ($LRR$).
Step 2: Key Formula or Approach:
\[ \text{Total Credit Created} = \text{Initial Deposit} \times \text{Money Multiplier } (k) \]
\[ k = \frac{1}{LRR} \]
Step 3: Detailed Explanation:
Let's assume the Initial Deposit is ₹ 10,000.
Case 1: Let $LRR = 20%$ or $0.2$.
\[ k = \frac{1}{0.2} = 5 \]
\[ \text{Total Credit} = 10,000 \times 5 = ₹ 50,000 \]
Case 2: Let $LRR$ decrease to $10%$ or $0.1$ (Value of multiplier increases).
\[ k = \frac{1}{0.1} = 10 \]
\[ \text{Total Credit} = 10,000 \times 10 = ₹ 1,00,000 \]
As seen in the example, when the money multiplier increased from 5 to 10, the total credit created rose from ₹ 50,000 to ₹ 1,00,000, while the initial deposit remained constant.
Step 4: Final Answer:
Hence, the statement is correct (defended) because the total credit creation is directly proportional to the money multiplier.
B
Step 1: Understanding the Concept:
This question refers to the ``Banker's Bank and Supervisor'' and the ``Clearing House'' functions of the Central Bank (RBI).
Step 2: Detailed Explanation:
1. Maintenance of Reserves: Commercial banks are required to keep a certain percentage of their deposits with the Central Bank as Cash Reserve Ratio ($CRR$).
2. Settlement of Claims: Since all commercial banks have accounts with the Central Bank, it is easier for the Central Bank to settle claims between banks by making simple book entries.
3. Mechanism: If Bank A owes Bank B, the RBI simply debits Bank A's account and credits Bank B's account.
4. Benefit: This avoids the physical transfer of cash, reduces the transaction cost, and prevents liquidity crises in the banking system.
Step 3: Final Answer:
Agree. The Central Bank acts as a clearing house for commercial banks, utilizing their reserves to settle mutual debts efficiently.