Question

Explain the process of credit creation by commercial banks.

Answer 1

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 reserves. 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 lends the remaining portion (left after maintaining cash reserves) 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 banks lend loans to more and 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. It is due to this continuous process that the commercial banks are able to create credit money a multiple times of the initial deposits.
The process of credit creation can be better understood with the help of the following numerical example. For simplicity, let us assume that the entire commercial banking system is a single unit called 'banks'.
Suppose, initially the public deposited $Rs.1000$ with the banks. The banks kept a portion of these deposits with themselves as cash reserves (in accordance with CRR and SLR) and extend the rest as loans to the borrowers. Let us assume that the Legal Reserve Ratio (LRR) is $20\%$ or $0.20$ and the banks have maintained exactly the same amount as cash reserves (i.e. neither more nor less) This implies that banks will keep $20\%$ of the deposits received as reserves and the rest is given out as loans In other words, out of $Rs.1000$ (initial deposits), banks kept $Rs.200$ with themselves as reserves and the balance amount of $Rs.800(Rs.1,000-Rs.200)$ is given as loans. Also, suppose that all the transactions taking place in the economy are routed only through banks. Thus, the money spent by the borrowers again comes back to the banks as deposits. Hence, there is an increment in the demand deposits with the banks by $Rs.800$ (in the second round). Therefore, now the total deposits with the banks rises to $Rs.1,800(Rs.1,000+Rs.800)$.
Now, out of the new deposits of $Rs.800$, the banks will keep $20\%$ as reserves and the remaining amount is lent out i.e. $Rs.160$ is kept as reserves and the remaining $Rs.640$ is extended as loans When the borrower spends this borrowed amount either by cheques, demand drafts, etc. this amount is routed through the banks. Therefore, the money spent by the borrower comes back to the bank and the total deposits increase to $Rs.2,440(i.e.Rs.1800+Rs.640)$.
The same process continues and with each round the total deposits with the banks increases. However; in every subsequent round the cash reserves diminishes. The process comes to an end when the total cash reserves (aggregate of cash reserves from the subsequent rounds) become equal to the initial deposits of $Rs.1,000$ that was initially held by the banks.

Rounds	Deposits Received A	Loans Extended B	Cash Resrves $C=\frac{20}{100}\times A$
Initial	1,000	800	200
Round I	800	640	160
Round II	640	512	128
Round III	-	-	-
Round IV	-	-	-
-	-	-	-
-	-	-	-
Round N	-	-	-
Total	5,000	4,000	1,000

In the schedule, it should be noted that the total amount of deposits recived, i.e. Rs. 5,000 is ascertained by the formula of money multiplier. Money multiplier is defined as the inverse of the Legal Reserve Ratio (LRR). Algebraically,

$M_m=\frac{1}{LRR}$

$M_m=\frac{1}{0.20}=5$ times

As the money multiplier is 5 times, so this implies that the total deposits $(Rs.5,000)$ increased by 5 times the intial deposite $(Rs.1,000)$ through the process of credit creation. This can be interpreted as the commerical banks have created money of $Rs.5,000$ from the deposits of $Rs.1,000$