Answer the following question.
What role does it play in determining the credit creation power of the banking system? Use a numerical illustration to explain.
Solution
The process of credit creation can be explained by taking an example of a bank XYZ. A depositor deposits Rs.10,000 in his savings account, which will become the demand deposit of the bank. Based on the assumption that not all customers will turn up at the same day to withdraw their deposits, the bank maintains a minimum cash reserve of 10 % of the demand deposits, i.e. Rs.1000.It lends the remaining amount of Rs.9000 in the form of a credit to other customers. This further creates deposits for the bank XYZ of Rs 9000. Now in the next round, out of Rs 9000, Rs 900 goes as cash reserves and the remaining Rs 8100 are extended as loans. And so the process will continue. Such a process will increase the money supply in the economy by the amount (times) of credit multiplier. The credit multiplier is given by:
Credit multiplier = `1/"CRR" = 1/10` % = 10
Therefore, the money supply will increase by 10 times and the total credit created in the economy will be equal to around Rs 1,00,000.
The same process can be supported by the following table:
| Rounds | Deposits Received A |
Loans Extended B |
Cash Reserves |
| Initial | 10,000 | 9000 | 1000 |
| Round I | 9000 | 8100 | 900 |
| Round II | 8100 | 7290 | 810 |
| Round III | - | - | - |
| Round IV | - | - | - |
| - | - | - | - |
| - | - | - | - |
| Round N | - | - | - |
| Total | 1,00,000 | 90,000 | 10,000 |
