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Credit creation by banks

Credit creation by banks

Banks act as an intermediary between the person who has excess of funds and one who is in need of funds. The deposits which are accepted for the purpose of lending or investment from the public are payable on demand or withdrawal through cheque, draft etc . Banks activate the resources which are laying idle and puts them for productive uses.

BANKS ARE ABLE TO ADD TO THE TOTAL MONEY SUPPLY (which is also an instrument of monetary policy) THROUGH THE PROCESS OF CREDIT CREATION.

Credit may be defined as funds available by one party to another party on a certain interest rate.Money supply is the total stock of money in the economy and has two components:-

(A) currency with the public

(B) demand deposits

The currency created by RBI is called the  high powered money.The commercial banks create the demand deposits which are also called bank money.

Commercial banks receive deposits from the public.These deposits are used by banks to advance loans.

Credit or money creation by banks is based on amount of initial deposits by the public and the legal reserve ratio.Legal reserve ratio or the LRR  is a proportion of the total amount of deposits which are legally compulsory for the banks to keep as cash.

The process of money  creation starts with say a deposit of Rs.100.The banks cannot use  the whole amount deposited to advance loans but only a fraction of it as stipulated by LRR.Now this LRR is composed of two components :-

  • Cash reserve ratio– a ratio of the deposits that banks have to keep with the central bank or the RBI.
  • Statutory Liquidity Ratio-a part of the deposits that banks keep with themselves which is used for withdrawals by the public.

INITIAL DEPOSIT: Rs.100

LRR  : 20%

Therefore, the banks keep Rs. 20 with them and lend the remaining Rs.80.Now since all the transactions are routed through banks,the money spent by borrowers comes back into the bank in the account of others who received the payment.This increases the demand deposits by Rs.80.

These deposits of Rs.80 have resulted due to the loan given by the bank initially.

The increase in total deposits are now =100+80=180.

Now when banks receive a deposit of Rs.80 they again keep 20% of it (Rs.16) and advance the remaining amount as loans (Rs.64).

This Rs.64 comes in bank through transaction in another account.The total deposits now are Rs.244 (100+80+64).

 

        Deposits  (Rs.)          Loans(Rs.)         Cash Reserves           (LRR=0.2)
INITIAL1)

2)

3)

4)

5)

6)

–

–

–

 10080

64

51.20

40.96

32.768

26.2144

–

–

–

 8064

51.20

40.96

32.768

26.2144

20.97152

–

–

–

 2016

12.80

10.24

8.192

6.5536

5.24288

–

–

–
TOTAL 500 400 100

 

This process continues, the deposits go on increasing. The deposit creation comes to an end when total cash reserves with the bank are equal to the initial deposit of Rs.100.

At the end total deposits stand at Rs.500 which is five times the initial amount.

There is a simple formula to determine how many times the total deposits would become of the initial deposits  :-

Money multiplier=1/LRR =1/0.2=5

And money creation =initial deposit×1/LRR =100×5=500

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Nishtha Ruhil
an economics honours graduate from Delhi university,currently pursuing post graduation from Punjab university.

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