Question

Write the mechanism of credit creation by commercial banks.

Explain the mechanism of credit creation by commercial banks with the help of an example.

Answer 1

Mechanism/Technique of Credit Creation by Commercial Banks:

• Bank credit refers to bank loans and advances.
• Money is said to be created when the banks, through their lending activities, make a net addition to the total supply of money in the economy.
• Money is said to be destroyed when the loans are repaid by the borrowers to the banks and consequently, the credit already created by the banks is wiped out in the process.
• Banks have the power to expand or contract demand deposits and they exercise this power through granting more or less loans and advances and acquiring other assets.
• This power of commercial banks to create deposits through expanding their loans and advances is known as credit creation.

Example of Credit Creation:

Round	Deposit Received (₹)	Cash Reserve (20%) (₹)	Loan Given (₹)
1	1,000	200	800
2	800	160	640
3	640	128	512
4	512	102.4	409.6

Total Credit Created ≈ ₹ 5,000