Question

Explain the process of money creation by commercial banks, giving numerical example.

Answer 1

Commercial banks plays an important role of 'money creator' in the economy. They have the capacity to generate credit through demand deposits. These demand deposits make credit more than the initial deposits.The process of money creation can be explained by taking an example;

Suppose a depositor deposits Rs.10,000 in his savings account of a bank XYZ, which will become the demand deposits of the bank. Based on the assumption that not all customers will turn up at the same day to withdraw their deposits, banks maintains a minimum cash reserve of 10% of the demand deposits, Rs.10,000. It lends the remaining amount of Rs.9000 in the form of credit to other customers. This further creates deposits for the bank XYZ. With the cash reserve of Rs.1000, the credit creation is worth Rs.10,000. So, the credit multiplier is given by:

$Creditmultiplier=\frac{1}{10\%}=10$

The money supply in the economy will increase by the amount (times) of credit multiplier.

$NUMERICALEXAMPLE;$

1. We will make some assumption;

(i) All banks are one unit.

(ii) All the transactions are made through banks.

2. Initial deposits are Rs.10,000 and the legal reserve requirement proposed by the central bank is 10%.

Then,

$Creditcreation=Initialdeposits\times \frac{1}{LRR}$

= $\frac{10,000}{0.1}$

= $Rs.1,00,000$

As we know that, $Moneymultiplier=\frac{1}{LRR}$, so

$Moneymultiplier=\frac{1}{0.1}$

which is $MM=10Times$

So, the money multiplier is 10 times the initial deposits.