Question

Aditi deposits 1000 in a bank which leads to an increase in money supply in the economy to the extent of 4000. Name and explain the process of this increase in money supply.

Answer 1

The process by which commercial banks increase the money supply is called credit creation.

Explanation:

Aditi deposits ₹ 1000 in the bank, which becomes a part of the bank’s primary deposits. Banks are required to keep a fraction of the deposit as Cash Reserve Ratio (CRR) with the Reserve Bank of India (RBI) and can lend out the remaining amount. Assuming the Reserve Ratio is 25%, the bank keeps ₹ 250 and lends out ₹ 750. The borrowed money is returned to the banking system, and the process continues.

Using the Money Multiplier Formula:

Total Money Supply

`= 1/"Reserve Ratio" xx "Initial Deposit"`

`= 1/0.25 xx 1000`

= 4,000

This results in an increase in money supply to ₹ 4000, even though the original deposit was only ₹ 1000.