Question

“When initial deposits in the credit creation process remains same, the total amount of credit created rises as the value of money multiplier increases.” Defend or refute the above statement with the help of hypothetical numerical example. OR “Central Bank maintains reserves of all commercial banks and use to settle interbank claims.” Do you agree with the given statement? Give valid explanation in support of your answer.

Hint:

Higher money multiplier → more credit creation
Central bank = banker’s bank + clearing house

Answer 1

(A) Credit Creation and Money Multiplier
Concept:
The total credit created by banks depends on the money multiplier: \[ \text{Money Multiplier} = \frac{1}{\text{CRR}} \] and \[ \text{Total Credit Creation} = \text{Initial Deposit} \times \text{Money Multiplier} \]
Step 1:Understanding the relationship

• Initial deposit remains constant
• If CRR (Cash Reserve Ratio) decreases → money multiplier increases
• Higher multiplier → more credit creation

Step 2:Numerical Example
Case 1: CRR = 20% \[ \text{Money Multiplier} = \frac{1}{0.2} = 5 \] Initial deposit = ₹1000 \[ \text{Total Credit} = 1000 \times 5 = 5000 \] Case 2: CRR = 10% \[ \text{Money Multiplier} = \frac{1}{0.1} = 10 \] \[ \text{Total Credit} = 1000 \times 10 = 10000 \]
Step 3:Comparison

• Initial deposit same (₹1000)
• Credit increased from ₹5000 to ₹10000

Conclusion: \[ \text{Statement is correct — higher multiplier leads to higher credit creation} \] (B) Role of Central Bank
Concept: Banker’s Bank
Central bank acts as:

• Banker to commercial banks
• Custodian of their reserves

Step 1:Maintaining reserves

• Commercial banks keep a part of their reserves with the central bank
• These reserves ensure liquidity and stability

Step 2:Settlement of interbank claims

• Banks make payments to each other (e.g., cheque clearing)
• These transactions are settled through accounts maintained with the central bank

Step 3:Example

• Bank A owes ₹10 lakh to Bank B
• Central bank transfers funds from Bank A’s account to Bank B’s account

Conclusion: \[ \text{Statement is correct — central bank maintains reserves and settles interbank claims} \]