Limits to Credit Creation and Money Multiplier

Assume that Mr. Thomas goes to a bank to take a loan of 5,000. Can the bank proffer this loan? If it does, and Mr. Thomas deposits the loan amount in the bank itself, then the total bank deposits and the total money distribution or supply will increase. The bank can go on creating as much money as it wants.

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 the central bank. The RBI determines a definite percentage of deposits that every bank must keep as reserves. This is done to make sure that no bank is overlending.

This is a legal requirement and mandatory for the banks to maintain. This is known as the required reserve ratio, the reserve ratio, or the cash reserve ratio (CRR).

Cash reserve ratio (CRR) = Percentage of deposits that a bank must keep as cash reserves

Apart from the CRR, banks are also required to keep some reserves in liquid form for the short term. This ratio is known as the statutory liquidity ratio or SLR.

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