Question

Explain briefly the process of credit creation by commercial banks.

Explain the money creation process by the commercial banks with the help of an example.

Answer 1

1. Credit creation (or money creation) is the expansion of derivative deposits. It is a process where a bank uses a part of its customer's deposits to offer loans to other individuals and businesses.
2. This results in more money created in an economy. Banks can expand their demand deposits as a multiple of their cash reserves became demand deposits serve as the principal medium of exchange.

Example: Example: Suppose the amount of initial deposit is ₹ 1000 and LRR is 10%. The banks will keep 10%, i.e. ₹ 100 as reserve and lend the remaining ₹ 900 to borrowers. The borrowers will spend this money. It is assumed that ₹ 900 comes back to the bank. Bank again keep 10% of ₹ 900, i.e., ₹ 90 reserve and lend ₹ 810. This will further raise the amount of deposits with the banks. In this way, deposits go on increasing. The number of times, the total deposits will become, is determined by the money multiplier:

Money Multiplier = `1/"LRR" = 1/0.10 = 10`

The total deposits will be: 

Initial deposits × Money Multiplier

= ₹ 1000 × 10

= ₹ 10,000