Share

# Explain the Credit Creation Role of Commercial Banks with the Help of a Numerical Example. - Economics

#### Question

Explain the credit creation role of commercial banks with the help of a numerical example.

#### Solution

The two important institutions involved in the money supply are the central bank (RBI as in India) and the commercial banks. While, RBI prints new money, on the other hand, the commercial banks multiply the money supplied by the RBI through the process of credit creation.

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).

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 rises to Rs 1,800 (Rs 1,000 + Rs 800).

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 increase to Rs 2,440 (i.e. Rs 1800 + Rs 640).

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 1,000 that was initially held by the banks.

 Rounds Deposits Received A Loans Extended B Cash Reserves C=20/100xxA 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 this way, at the end of all the rounds, we can see that the commercial banks have created 5,000 credit money from an initial deposit of Rs 1,000.

Is there an error in this question or solution?