Presume, Mr Thomas comes to this bank for a loan of ₹ 5,000. Can the bank proffer this loan? If it gives the loan and Mr Thomas deposits the loan amount in the bank itself, the total bank deposits and hence, the total money distribution or supply will increase. The banks can go on creating as much money as they want.
However, is there a constraint to money or credit creation by banks? Yes, there is and this is decided by the Reserve Bank of India (RBI) or Central Bank. The RBI determines a definite percentage of deposits which every bank must keep as reserves. This is done to make sure that no bank is ‘over lending’. This is a legal requirement and is necessary on the banks. This is known as the Required Reserve Ratio or the Reserve Ratio or Cash Reserve Ratio (CRR).
- Cash Reserve Ratio (CRR) = Percentage of deposits which a bank must keep as cash reserves with itself.
Apart from the CRR, banks are also needed to keep some reserves in liquid form in the short term. This ratio is called the Statutory Liquidity Ratio or SLR.
The above mentioned is the concept that is explained in detail about Limits to Credit Creation and Money Multiplier. To know more, stay tuned to BYJU’S.