Question

Explain Money Creation / Credit Creation by the commercial banks with the help of a numerical example.

Answer 1

The money (or deposit or credit) creation by the commercial banks is determined by the amount of initial deposit and the legal reserve ratio (LRR). Suppose the amount of Initial deposit is $10,000$ and LRR is $0.20$. The banks will keep 20% i.e. $Rs.2,000$ as reserve and lend the remaining $Rs.8,000$. Those who borrow, will spend this money. It is assumed that? $Rs.8,000$ comes back to the banks. This raises total deposits to $18,000$. Banks again keep $20$ of $Rs.8,000$, i.e. $Rs.1,600$ as reserve and lend $Rs.6,400$. This further raises the amount of deposits with the banks. In this way, deposits go on increasing @ $80$ of the last deposit. The number of times, the total deposits will become, is determined by the deposit or money multiplier:
Money Multiplier $=\frac{1}{LRR}=\frac{1}{0.2}=5$
The total deposits will be: Initial deposit $\times$ Money Multiplier $=10,000\times 5=Rs.50,000$.