Question

"Although Central Bank issues currency we say commercial banks create money." Explain how.

Answer 1

This is because of the unique feature of commercial banks i.e., credit creation. Suppose deposits of Rs. 100 are made in a bank. The minimum reserve requirement is being put at 10% of the total deposits. Bank will keep a cash reserve equal to Rs. 10 only and lend the remaining amount of Rs. 90. For this, the bank does not have not to part with its cash reserves, instead, borrowers are credited with chequable deposits. This is the first round of credit creation and equal to 90% of the initial deposits. Borrowers will use the deposits (which are raised through banks) to meet their obligations to their creditors, by paying them, most probably in the form of cheques drawn on the bank. They will deposit the same in their respective bank accounts. The bank gets the new deposits. It keeps 10% of these deposits i.e Rs. 9 as cash and lends the remaining Rs. 81. Thus, this is the second round of credit creation. In the same manner, the third round creation of deposits will be 90% of Rs. 81, i.e., Rs. 72.90 and in the fourth round it will be 90% of Rs. 72.90, i.e., Rs. 65.61 and so on. This follows and creations in each of the further rounds will be 90% of the previous round. In each round, the increase becomes smaller and smaller and ultimately, it becomes zero. The sum total of all deposits will ultimately be Rs. 1000, i.e., ten times the initial deposit.

$DepositMultiplier=\frac{1}{\text{Reserve Deposit Ratio}}=\frac{1}{10\%}=\frac{100}{10}=10$

$\begin{array}{cccc}& Deposit(Rs.)& \text{Loan (Rs.)}& \text{Cash Reserve (Rs.)}\\ \text{Initial}& 100& 90& 10\\ 1^{st}\text{Round}& 90& 81& 9\\ 2^{nd}\text{Round}& 81& 72.90& 8.10\\ & :& :& :\\ & :& :& :\\ \text{Total}& 1000& 900& 100\end{array}$