“An increase in the credit creation capacity of commercial banks has a direct impact on the money supply in an economy.”
Discuss the given statement.
“An increase in the credit creation capacity of commercial banks has a direct impact on the money supply in an economy.”
Discuss the given statement.
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Solution and Explanation
Commercial banks perform the function of credit creation.} The amount of credit creation depends upon the initial deposits and the reserve ratio maintained by banks. This process plays a crucial role in determining the money supply in an economy.
Mechanism of Credit Creation and Its Impact on Money Supply : Credit Creation by Banks: Commercial banks accept deposits from individuals and businesses. A portion of these deposits is kept as reserves, while the remaining amount is given out as loans. The money lent by banks is again deposited in the banking system, creating multiple layers of deposits, thereby increasing the money supply.
Role of the Reserve Ratio: The credit creation capacity of commercial banks depends on the reserve ratio (Cash Reserve Ratio - CRR and Statutory Liquidity Ratio - SLR) set by the Central Bank. A decrease in these ratios increases the lending capacity of banks, leading to higher credit creation and a greater money supply.
Money Multiplier Effect: When banks lend money, the same money re-enters the banking system as deposits, enabling further lending. This continuous cycle leads to the money multiplier effect , where the total money supply becomes a multiple of the initial deposit.
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