How do commercial banks create deposits? Explain.
Commercial banks are the important source of
money supply in the economy. They contribute to money supply by creating
credit.
They create credit out of their total deposits which are many more times
greater than their initial level of deposits.
Money creation is determined by:
(i) The amount of the initial fresh deposits.
(ii) The Legal Reserve Ratio (LRR), which is the minimum ratio of deposits
legally required to be kept as cash by the banks.
Money Creation=Initial Deposits×1LRR
Example, let the LRR be 20%,
Fresh deposits = Rs 10,000
As required, the banks keep 20% i.e. Rs 2000 as cash. Suppose the banks lend
the remaining amount of Rs 8000. Those persons who borrow, use this money for
making payments.
Further, it is also assumed that, persons receiving the payment will deposit
the amount in the bank. This will result in banks receiving fresh deposits of
Rs 8000. The banks again keep Rs 1600 as cash and lend Rs 6400, which is also
80% of the last deposit, the money again comes back to the banks leading to a
fresh deposit of Rs 6400. In this way, the money goes on multiplying and
ultimately, total money creation is Rs 50000.
According to the formula,
Money Creation=10000×120%=Rs50,000
Commercial banks are the important source of
money supply in the economy. They contribute to money supply by creating
credit.
They create credit out of their total deposits which are many more times
greater than their initial level of deposits.
Money creation is determined by:
(i) The amount of the initial fresh deposits.
(ii) The Legal Reserve Ratio (LRR), which is the minimum ratio of deposits
legally required to be kept as cash by the banks.
Money Creation=Initial Deposits×1LRR
Example, let the LRR be 20%,
Fresh deposits = Rs 10,000
As required, the banks keep 20% i.e. Rs 2000 as cash. Suppose the banks lend
the remaining amount of Rs 8000. Those persons who borrow, use this money for
making payments.
Further, it is also assumed that, persons receiving the payment will deposit
the amount in the bank. This will result in banks receiving fresh deposits of
Rs 8000. The banks again keep Rs 1600 as cash and lend Rs 6400, which is also
80% of the last deposit, the money again comes back to the banks leading to a
fresh deposit of Rs 6400. In this way, the money goes on multiplying and
ultimately, total money creation is Rs 50000.
According to the formula,
Money Creation=10000×120%=Rs50,000
