Explain the Process of Credit Creation by Commercial Banks.
Explain the Process of Credit Creation by Commercial Banks.
The process of credit creation by commercial banks can be easily understood by the following example.
Suppose a person, say X, deposits ₹ 2000, with a bank and the LRR is 10% which means the bank keeps only the minimum required ₹ 200 as cash reserve.
The bank can use the remaining amount ₹ 1800 (= 2000-200) for giving a loan to someone. The bank lends ₹ 1800 to, say F, for this purpose and an account is opened in the name of Y and the amount is credited in his account. This is the first round of credit creation in the form of a secondary deposit (₹ 1800) which equals 90% of the initial deposit.
Now again from the deposit of Y, the bank keeps 10% or LRR i.e., 180 and remaining ₹ 1620 is advanced to, say, Z. The bank gets a new demand deposit. This is the second round of credit creation till secondary deposit becomes zero. In the end, the volume of total credit created becomes multiple of the initial deposit.
The quantitative outcome is called money multiplier. In short, money (or credit) creation by commercial banks depends on two factors: (i) amount of initial deposit and (ii) LRR. Symbolically:
Total credit creation = Initial deposit × (1/LRR)
Also read:
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The process of credit creation by commercial banks can be easily understood by the following example.
Suppose a person, say X, deposits ₹ 2000, with a bank and the LRR is 10% which means the bank keeps only the minimum required ₹ 200 as cash reserve.
The bank can use the remaining amount ₹ 1800 (= 2000-200) for giving a loan to someone. The bank lends ₹ 1800 to, say F, for this purpose and an account is opened in the name of Y and the amount is credited in his account. This is the first round of credit creation in the form of a secondary deposit (₹ 1800) which equals 90% of the initial deposit.
Now again from the deposit of Y, the bank keeps 10% or LRR i.e., 180 and remaining ₹ 1620 is advanced to, say, Z. The bank gets a new demand deposit. This is the second round of credit creation till secondary deposit becomes zero. In the end, the volume of total credit created becomes multiple of the initial deposit.
The quantitative outcome is called money multiplier. In short, money (or credit) creation by commercial banks depends on two factors: (i) amount of initial deposit and (ii) LRR. Symbolically:
Total credit creation = Initial deposit × (1/LRR)
Also read:
Stay connected with BYJU’S for more such questions and answers on various commerce topics.
