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Question

Currency is issued by the central bank, yet we say that commercial banks create money. Explain. How is this money creation by commercial banks likely to affect the national income? Explain.


Solution

It is true that commercial Banks creates money through credit creation. The Central Bank issues credit on basis of primary deposits and create money many more times than the deposits. These banks lend money for productive work which increase production, productivity and ultimately National Income.
We know that RBI prints new, money, while on the other hand, commercial bank multiplies money supplied by the RBI through the process of credit creation. People deposit money in their respective bank accounts. As per the central bank guidelines, the commercial banks are required to maintain a portion of total deposits in form of cash reserve.
With the help of the past experiences, the commercial banks know that not all the depositor will turn-up for withdrawal at the same day. Consequently, the commercial banks lend the remaining portion (left after maintaining cash reserve of the total deposits to the general public in form of credit, loans and advances. It is the second portion of the total deposits that is responsible for the credit creation (credit money).
The process of creation of credit money begins as soon as the commercial banks start the lending process. The amount of the credit money increases as the bank lend loans to more number of people in the economy. The deposit of money by the people in the banks and the subsequent lending of loans by the commercial banks is a never-ending process. This lending process of the commercial banks increases the rate of investment and production in the economy, which in turn help in improving the national income in the economy.


Economics

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