Explain the process of money creation …

It is one of the most important activities of commercial banks. Through the process of money creation, commercial banks are able to create credit, which is in far excess of the initial deposits. However, it is legally compulsory for the banks to keep a certain minimum fraction of their deposits as reserves. The fraction is called the Legal Reserve Ratio (LRR) and is fixed by the central bank. Banks do not keep 100% reserves against the deposits. They keep reserves only to the extent indicated by the Central Bank.

Now coming to the money creation process of commercial banks, it can be ascertained by using the given formula
Money Creation = Initial Deposits {tex}\times \frac { 1 } { \mathrm { LRR } }{/tex}. 
For example, let the LRR be 20% and Initial deposits = Rs.10,000.  As required, the banks keep 20% i.e. Rs. 2,000 as cash and lend the remaining amount of Rs. 8,000.
Further, it is also assumed that persons receiving the debt will deposit the amount in the bank. This will result in banks receiving fresh deposits of Rs. 8,000. The banks again keep Rs. 1,600 as cash and lend Rs. 6,400, which is also 80% of the last deposit, this money also 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 according to the formula, will be

Money Creation ={tex}10,000 \times \frac { 1 } { 20 \% }{/tex}

=Rs. 50,000.