Explain the Process of Money Creation by the Commercial Banks with the Help of a Numerical Example. - Economics

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

Solution

The process of money creation by the commercial banks starts as soon as people deposit money in their respective bank accounts. After receiving the deposits, as per the central bank guidelines, the commercial banks maintain a portion of total deposits in form of cash reserves. The remaining portion left after maintaining cash reserves of the total deposits is then lend by the commercial bank to the general public in form of credit, loans and advances. Now assuming that all transactions in the economy are routed through the commercial banks, then the money borrowed by the borrowers again comes back to the banks in form of deposits. The commercial banks again keep a portion of the deposits as reserves and lend the rest. 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 a multiple times of the initial deposits.

The process of creation of money is explained with the help of the following numerical example.

 Rounds Deposits Received Loans Extended Cash Reserves Initial 10,000 8,000 2,000 Ist Round 8,000 6,400 1,600 IInd Round 6400 5,120 1,280 - - - - nth Round - - - Total 50,000 40,000 10,000

Suppose, initially the public deposited Rs 10,000 with the banks. Assuming the Legal Reserve Ratio to be 20%, the banks keep Rs 2,000 as minimum cash reserves and lend the balance amount of Rs 8,000 (Rs 10,000 – Rs 2,000) in form of loans and advances to the general public.

Now, if all the transactions taking place in the economy are routed only through banks then, the money borrowed by the borrowers is again routed back to the banks in form of deposits. Hence, in the second round there is an increment in the deposits with the banks by Rs 8,000 and the total deposits with the banks now rises to Rs 18,000 (that is, Rs 10,000 + Rs 8,000). Now, out of the new deposits of Rs 8,000, the banks will keep 20% as reserves (that is, Rs 1600) and lend the remaining amount (that is, Rs 6,400). Again, this money will come back to the bank and in the third round, the total deposits rises to Rs 24,400 (i.e. Rs 18,000 + Rs 6,400).

The same process continues and with each round the total deposits with the banks increases. However; in every subsequent round the cash reserves diminishes. 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 10,000 that were initially held by the banks. As per the above schedule, with the initial deposits of Rs 10,000, the commercial banks have created money of Rs 50,000.

Concept: Commercial Banks
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