Money or Credit Creation by Commercial Banks Commercial banks increases the flow of money in an economy by credit creation. This process of credit creation is an outcome of its two primary functions, i.e. acceptance of loans and advancement of deposits. The banks issue loans from their cash reserves with the confidence on their historical experience that all depositors will not withdraw their funds at the same time. In this way, commercial banks create credit many more times than their cash reserves and contributes to increase money supply in the economy. It depends on initial level of deposits and money multiplier.
Money creation is determined by :
(i) The amount of the initial fresh deposits.
(ii) The Legel Reserve Ratio (LRR) is the minimum ratio of deposits legally required to be kept as cash by the banks.
(iii) Money Multiplies = 1/LRR
Total Money Creation = Initial Deposits x 1/LRR
e.g. Let the LRR be 20%
Fresh deposits = Rs. 10000
Amount required by the banks to keep = Rs. 2000 as cash suppose the banks lend the remaining amount of Rs. 8000. The commercial banks also know by way of their historical experience that all the depositors would not show up in the banks to withdraw all their deposits at a point of time. Those person who borrow, use this money for making payments, also all the transactions will be carried out through banks.
Further, it is also assumed that, those who receive fresh deposits of Rs. 8000, the banks again keep Rs. 1,600 as cash and lend Rs. 6,400, which is also 80% of the last deposit, the money again comes back to the banks leading to a fresh deposit of Rs.6,400. In this way, the money goes on multiplying and ultimately total money creation is Rs.50,000.
As, according to the formula
Total money creation =10,000 x 1/20 x 100 = Rs. 50,000
Gaurav Seth 5 years, 3 months ago
Money or Credit Creation by Commercial Banks Commercial banks increases the flow of money in an economy by credit creation. This process of credit creation is an outcome of its two primary functions, i.e. acceptance of loans and advancement of deposits. The banks issue loans from their cash reserves with the confidence on their historical experience that all depositors will not withdraw their funds at the same time. In this way, commercial banks create credit many more times than their cash reserves and contributes to increase money supply in the economy. It depends on initial level of deposits and money multiplier.
Money creation is determined by :
(i) The amount of the initial fresh deposits.
(ii) The Legel Reserve Ratio (LRR) is the minimum ratio of deposits legally required to be kept as cash by the banks.
(iii) Money Multiplies = 1/LRR
Total Money Creation = Initial Deposits x 1/LRR
e.g. Let the LRR be 20%
Fresh deposits = Rs. 10000
Amount required by the banks to keep = Rs. 2000 as cash suppose the banks lend the remaining amount of Rs. 8000. The commercial banks also know by way of their historical experience that all the depositors would not show up in the banks to withdraw all their deposits at a point of time. Those person who borrow, use this money for making payments, also all the transactions will be carried out through banks.
Further, it is also assumed that, those who receive fresh deposits of Rs. 8000, the banks again keep Rs. 1,600 as cash and lend Rs. 6,400, which is also 80% of the last deposit, the money again comes back to the banks leading to a fresh deposit of Rs.6,400. In this way, the money goes on multiplying and ultimately total money creation is Rs.50,000.
As, according to the formula
Total money creation =10,000 x 1/20 x 100 = Rs. 50,000
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