Question

Credit creation is inversely related to the reserve deposit ratio ‟ .Justify
the given statement ,using a hypothetical example..

Answer 1

Answer:

ANSWER

Credit creation is the most importnt function of commercial banks. Commercial banks accept deposits and lend money to the needy borrowers. Through this process they create two types of deposits, (i) primary deposits and (ii) derivative or active deposits.

The former deposits refers to the cash or cheque deposited by a customer in a bank. The banker merely accepts cash and converts it into a deposit. But, this is merely a passive role performed by the banks,because these primary deposits do not add to the money stock in the economy. Banks know, from their experience and observation, that not all the customers will withdraw their deposits on any single day. However, commercial banks cannot use the entire amount of public deposits for lending purposes. They are required to keep a certain percentage of amount as reserve with the Central Bank for serving the cash requirements of depositors. After keeping the required amount of reserves, commercial banks lend the remaining portion of public deposits as loans. The amount of reserve maintained by the banks is known as Cash Reserve Ratio (CRR) and is determined by the Central Bank.

The process of credit creation by commercial banks is explained as follows:

Suppose ‘A’ deposit Rs. 10,000 in a bank X, which is the primary deposit of the bank. The cash reserve requirement of the Central Bank is 10%. Then, bank X will keep Rs. 1000 as reserve with the Central Bank and will lend remaining Rs. 9000 to needy borrowers.

In other words, the bank X does not give B cash while sanctioning the loan. Instead the bank merely opens a loan account in the name of B and credits to his account Rs. 9000. Then B pays to C, to whom he owes Rs. 9000, by way of cheque to settle his account with C.

C now deposits the cheque of Rs. 9000 in Y bank. The bank Y, after keeping a sum of Rs. 900 as CRR requirement of the Central Bank, lends Rs. 8100 to another borrower D. Thus, this process of deposits and credit creation continues till the reserves with commercial banks becomes zero.

Hence, the bank gets new deposit from the loan given and actively creates this new deposit. Thats is why it is always said that loans create deposits. The new deposit created in this manner will add to the money stock of the economy. Whenever the loan is returned by the borrower to the bank, then there is no further possibility of creating new deposit.

Answer 2

Answer:

Explanation:

The value of credit creation is inversely related to the reserve deposit ratio .Lets take an example to prove this statement , suppose the reserve ratio is 0.4 and the value of the initial deposit is Rs .1,000 crores.

Here we have , total credit created = $\frac{1}{reserved ratio} (initial deposits)$

                                                          = $\frac{1}{0.4} (1000)$ =  2,500 crores

Now , if the reserve ratio is increased  to 0.5

Then , total credit created = $\frac{1}{0.5} (1000)$ = 2,000 crores

Hence , the above example show that the credit creation is inversely related to the reserve deposit ratio .

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