Question

Discuss briefly the credit creation process of the banking system, using a hypothetical numerical example?​

Answer 1

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The credit creation by commercial banks is determined by amount of initial deposit and the legal reserve ratio.

Suppose customer deposits Rs. 1000 in bank. Bank has to pay interest on this amount for which bank should lend this money to someone. A part of the amount is to be retained with bank to meet its customer’s obligations. Say, if LRR is 20%, the banks will keep 20% of deposits as reserves and will lend remaining 80% i.e. Rs.800. Those who borrow will spend this money and same 800 will come back to banks in form of deposits. This raises the total deposits to Rs.1,800 now. Banks again keep 20% of Rs. 800 as reserve and lend Rs. 640 to those who needs. This will further raise the deposits with banks. In this way deposits will go on increasing 80% of the last deposit. The number of times the total deposit will become, is determined by money multiplier i.e. 1/LRR = 1/0.2 = 5 times.

Total deposits will be Initial Deposits X Money Multiplier = Rs.1000 X 5 = Rs. 5,000....♥

Answer 2

The credit creation by commercial banks is determined by amount of initial deposit and the legal reserve ratio.

Suppose customer deposits Rs. 1000 in bank. Bank has to pay interest on this amount for which bank should lend this money to someone. A part of the amount is to be retained with bank to meet its customer’s obligations. Say, if LRR is 20%, the banks will keep 20% of deposits as reserves and will lend remaining 80% i.e. Rs.800. Those who borrow will spend this money and same 800 will come back to banks in form of deposits. This raises the total deposits to Rs.1,800 now. Banks again keep 20% of Rs. 800 as reserve and lend Rs. 640 to those who needs. This will further raise the deposits with banks. In this way deposits will go on increasing 80% of the last deposit. The number of times the total deposit will become, is determined by money multiplier i.e. 1/LRR = 1/0.2 = 5 times.

Total deposits will be Initial Deposits X Money Multiplier = Rs.1000 X 5 = Rs. 5,000....♥