Limits to Credit Creation and Money Multiplier

• Banks cannot create unlimited money; there is a limit to money/credit creation.
• This limit is determined by the Central Bank (RBI) through reserve requirements.

• Cash Reserve Ratio (CRR) is the percentage of deposits that every bank must keep as cash reserves.
• It is fixed by the RBI and is a legal requirement.
• Its purpose is to prevent over-lending by banks.

CRR = (Cash Reserves / Total Deposits) × 100

• Apart from CRR, banks must also keep some reserves in liquid form in the short term.
• This ratio is called the Statutory Liquidity Ratio (SLR).

• Fictional economy with one bank.
• Initial deposit: Leela deposits Rs 100.
• CRR = 20 %
• Required cash reserves = Rs 20 (20% of 100).
• Loanable amount = Rs 80 (100 – 20).
• The statutory reserve ratio limits the amount of credit the bank can create.

Round 1:

• Deposit = Rs 100.
• Required reserve = Rs 20.
• Loan to Jaspal Kaur = Rs 80.

Round 2:

• A loan of Rs 80 comes back as a deposit; total deposit = Rs 180.
• Required reserve = 20% of 180 = Rs 36.
• Bank started with Rs 100 as cash, so it can lend again = Rs 64 (100 – 36).
• Loan to Junaid = Rs 64, which again appears as deposit.

The process repeats till:

• Required reserves = Rs 100.
• Total deposits = Rs 500 (because 20% of 500 = 100).

• Column 1: Round number.
• Column 2: Total deposits at beginning of round.
• Column 3: Required reserves = 20% of deposits, to be deposited with RBI.
• Column 4: Loans made in each round.
• Loan made in one round becomes part of deposits in the next round.

\[\text{Money Multiplier}=\frac{1}{\text{Cash Reserve Ratio}}\]

• A bank keeps 20% of deposits as reserves, i.e., Rs 100 for deposits of Rs 500.
• Reserves of Rs 100 can support deposits of Rs 500.
• A bank can give loans of Rs 400.

Money supply:

• M1 = Currency + Deposits = 0 + 500 = 500.
• Money supply increases from Rs 100 to Rs 500.

With CRR = 20 %, bank cannot lend beyond Rs 400.

Reserve requirement acts as a limit to money creation.

Money Multiplier:

• Money Multiplier = 1 over Cash Reserve Ratio.
• Here: 1 over 20 per cent = 1 over 0.2 = 5.
• Reserves of Rs 100 create deposits of Rs (5 × 100) = Rs 500.

• CRR limits the amount of credit banks can create.
• Higher CRR → Lower credit creation and money supply.
• Lower CRR → Higher credit creation and money supply.
• Loans become deposits, leading to multiple rounds of credit creation.
• Money Multiplier = 1 / CRR.