Question

Explain the process of `Credit Creation' by Commercial Banks with a numerical example.

Hint:

Credit Creation is limited by two things: (1) The LRR set by the Central Bank, and (2) The willingness of people to keep money in the bank rather than as cash.

Answer 1

Step 1: Understanding the Concept:
Commercial Banks have the unique ability to create credit (money) far in excess of their primary deposits. This is possible because banks are required to keep only a fraction (LRR) of deposits as reserves, lending out the rest.

Step 2: Detailed Explanation:
Numerical Example: Suppose Initial Deposit = ₹ 1,000 and $LRR = 10%$.

This process continues infinitely until all reserves are used.
Total Deposits (Money) Created:
\[ \text{Total Deposits} = \text{Initial Deposit} \times \frac{1}{LRR} = 1,000 \times \frac{1}{0.1} = ₹ 10,000 \]
Thus, an initial deposit of ₹ 1,000 leads to a total money supply of ₹ 10,000 in the banking system.

Step 3: Final Answer:
Commercial Banks create ₹ 10,000 of total deposits from an initial deposit of ₹ 1,000 with an LRR of 10%, using the credit multiplier process.