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Answer the Following Question. Explain the Money Creation Function of Commercial Banks. - Economics

Answer in Brief

Answer the following question.
Explain the money creation function of commercial banks.

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Solution

The Process of Creation of Money 
The two important institutions involved in the money supply are the central bank (RBI as in India) and the commercial banks. On one hand, RBI prints new money (seigniorage), while on the other hand, the commercial banks multiply the money supplied by the RBI through the process of credit creation. It should be noted that the printing of money by RBI forms a very small proportion of the total money supply. The money created by commercial banks is known as credit money. 
People deposit money in their respective bank accounts. As per the central bank guidelines, commercial banks are required to maintain a portion of total deposits in the form of cash reserves. With the help of the past experiences, the commercial banks know that not all the depositor's will turn-up for withdrawal at the same day. Consequently, the commercial banks lend the remaining portion (left after maintaining cash reserves) of the total deposits to the general public in the form of credit, loans, and advances. It is the second portion of the total deposits that is responsible for the credit creation (credit money). The process of creation of credit money begins as soon as the commercial banks start the lending process. The amount of credit money increases as the banks lend loans to more and more number of people in the economy. The deposit of money by the people in the banks and the subsequent lending of loans by the commercial banks is a never-ending process. It is due to this continuous process that the commercial banks are able to create credit money multiple times of the initial deposits. 
The process of credit creation can be better understood with the help of the following numerical example. For simplicity, let us assume that the entire commercial banking system is a single unit called 'banks'.
Suppose, initially the public deposited Rs 1000 with the banks. The banks kept a portion of these deposits with themselves as cash reserves (in accordance with CRR and SLR) and extend the rest as loans to the borrowers. Let us assume that the Legal Reserve Ratio (LRR) is 20% or 0.20 and the banks have maintained exactly the same amount as cash reserves (i.e. neither more nor less).
This implies that banks will keep 20% of the deposits received as reserves and the rest is given out as loans. In other words, out of Rs 1000 (initial deposits), banks kept Rs 200 with themselves as reserves and the balance amount of Rs 800 (Rs 1,000 - Rs 200) is given as loans. Also, suppose that all the transactions taking place in the economy are routed only through banks. Thus, the money spent by the borrowers again comes back to the banks as deposits. Hence, there is an increment in the demand deposits with the banks by Rs 800 (in the second round). Therefore, now the total deposits with the banks rise to Rs 1,800 (Rs 1,000 + Rs 800).
Now, out of the new deposits of Rs 800, the banks will keep 20% as reserves and the remaining amount is lent out i.e. Rs160 is kept as reserves and the remaining Rs 640 is extended as loans. When the borrower spends this borrowed amount either by cheques, demand drafts, etc. this amount is routed through the banks. Therefore, the money spent by the borrower comes back to the bank and the total deposits increased to Rs 2,440 (i.e. Rs 1800 + Rs 640).
The same process continues and with each round the total deposits with the bank's increases. However; in every subsequent round, the cash reserves diminish. The process comes to an end when the total cash reserves (aggregate of cash reserves from the subsequent rounds) become equal to the initial deposits of Rs 1,000 that were initially held by the banks.

Rounds Deposits Received
A
Loans Extended
B

Cash Reserves

C = `20/100` x A

Initial 1,000 800 200
Round I 800 640 160
Round II 640 512 128
Round III - - -
Round IV - - -
. - - -
. - - -
Round N - - -
Total 5,000 4,000 1,000

In the schedule, it should be noted that the total amount of deposits received, i.e. Rs 5,000 is ascertained by the formula of the money multiplier. The money multiplier is defined as the inverse of the Legal Reserve Ratio (LRR). Algebraically, 

`"M"_m = (1)/"LRR"`

`"M"_m = (1)/(0.20) = 5"times"`

As the money multiplier is 5 times, so this implies that the total deposits (Rs. 5,000) increased by 5 times the initial deposits (Rs 1,000) through the process of credit creation. This can be interpreted as the commercial banks have created money of Rs 5,000 from the deposits of Rs 1,000.

Concept: Commercial Banks
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