Using a numerical example, elaborate the credit creation process as handled by the commercial banks.
Using a numerical example, elaborate the credit creation process as handled by the commercial banks.
Money or credit creation is one of the most important functions of commercial banks. It is the process of expansion of credit through derivative deposits. Money creation by banks is determined by:
1. The amount of initial deposit
2. The cash reserve ratio
The process of credit creation is based on the following two assumptions:
1. The entire commercial banking system is one unit termed as "Banks".
2. All receipts and payments are routed through banks.
Suppose that the initial deposit in banks is Rs. 1,000 and CRR is 10%. It means that the banks are required to keep only 10% of deposits (i.e, Rs.1,000×10100=100 ) as cash reserves and are free to lend the remaining Rs.900.
Banks deposit this remaining amount (Rs.900) in the accounts of the borrowers, thus creating a secondary deposit. Suppose the borrowers withdraw the entire amount and make payments for goods and services received. The sellers of these goods and services receive Rs.900 as revenues and deposit the same in their bank accounts. This will increase the total demand deposits of banks by Rs.900
The banks again keep 10% (i.e,Rs.900×10100=90 ) of the new deposits as cash reserves and lend the remaining amount of Rs.810.
This way the deposits keep increasing, with the deposit in each successive round being 90% of the previous round. The working of the process of credit creation has been shown in the following table.
Process of Money Creation
RoundDeposits (Rs.)Cash ReservesLoans (Rs.)(CRR =10%)Initial deposit1,000100900First round90090810Second81081729........................Total10,0001,0009,000
Money Multiplier (MM) = 1CRR=110×100=10
Total demand deposits = Money Multiplier × Cash Reserves
= 10×1,000=Rs.10,000
From the example, we can see that banks are able to create total deposits of Rs. 10,000 which is 10 times the initial deposits.
Money or credit creation is one of the most important functions of commercial banks. It is the process of expansion of credit through derivative deposits. Money creation by banks is determined by:
1. The amount of initial deposit
2. The cash reserve ratio
The process of credit creation is based on the following two assumptions:
1. The entire commercial banking system is one unit termed as "Banks".
2. All receipts and payments are routed through banks.
Suppose that the initial deposit in banks is Rs. 1,000 and CRR is 10%. It means that the banks are required to keep only 10% of deposits (i.e, Rs.1,000×10100=100 ) as cash reserves and are free to lend the remaining Rs.900.
Banks deposit this remaining amount (Rs.900) in the accounts of the borrowers, thus creating a secondary deposit. Suppose the borrowers withdraw the entire amount and make payments for goods and services received. The sellers of these goods and services receive Rs.900 as revenues and deposit the same in their bank accounts. This will increase the total demand deposits of banks by Rs.900
The banks again keep 10% (i.e,Rs.900×10100=90 ) of the new deposits as cash reserves and lend the remaining amount of Rs.810.
This way the deposits keep increasing, with the deposit in each successive round being 90% of the previous round. The working of the process of credit creation has been shown in the following table.
Process of Money Creation
RoundDeposits (Rs.)Cash ReservesLoans (Rs.)(CRR =10%)Initial deposit1,000100900First round90090810Second81081729........................Total10,0001,0009,000
Money Multiplier (MM) = 1CRR=110×100=10
Total demand deposits = Money Multiplier × Cash Reserves
= 10×1,000=Rs.10,000
From the example, we can see that banks are able to create total deposits of Rs. 10,000 which is 10 times the initial deposits.
