explain the process of credit creation by commercial bank........ don't spam.... I have seen google......
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distinguish between revenue and fiscal deficit. and primary deficit.......
Answers
First Part:
(People deposit money in their respective bank accounts. As per the central bank guidelines, the commercial banks are required to maintain a portion of total deposits in form of cash reserves. With the help of the past experiences, the commercial banks know that not all the depositor will turn-up for withdrawal at the same day. Consequently, the commercial banks lends the remaining portion (left after maintaining cash reserves) of the total deposits to the general public in form of credit, loans and advances. It is the second portion of the total deposits that is responsible for the credit creation (credit money). The process of creation of credit money begins as soon as the commercial banks start the lending process. The amount of the credit money increases as the banks lend loans to more and more number of people in the economy. The deposit of money by the people in the banks and the subsequent lending of loans by the commercial banks is a never-ending process. It is due to this continuous process that the commercial banks are able to create credit money a multiple times of the initial deposits.
The process of credit creation can be better understood with the help of the following numerical example. For simplicity, let us assume that the entire commercial banking system is a single unit called 'banks'.
Suppose, initially the public deposited Rs.1000 with the banks. The banks kept a portion of these deposits with themselves as cash reserves (in accordance with CRR and SLR) and extend the rest as loans to the borrowers. Let us assume that the Legal Reserve Ratio (LRR) is 20% or 0.20 and the banks have maintained exactly the same amount as cash reserves (i.e. neither more nor less) This implies that banks will keep 20% of the deposits received as reserves and the rest is given out as loans In other words, out of Rs.1000 (initial deposits), banks kept Rs.200 with themselves as reserves and the balance amount of Rs.800(Rs.1,000−Rs.200) is given as loans. Also, suppose that all the transactions taking place in the economy are routed only through banks. Thus, the money spent by the borrowers again comes back to the banks as deposits. Hence, there is an increment in the demand deposits with the banks by Rs.800 (in the second round). Therefore, now the total deposits with the banks rises to Rs.1,800(Rs.1,000+Rs.800).
Now, out of the new deposits of Rs.800, the banks will keep 20% as reserves and the remaining amount is lent out i.e. Rs.160 is kept as reserves and the remaining Rs.640 is extended as loans When the borrower spends this borrowed amount either by cheques, demand drafts, etc. this amount is routed through the banks. Therefore, the money spent by the borrower comes back to the bank and the total deposits increase to Rs.2,440(i.e.Rs.1800+Rs.640).
The same process continues and with each round the total deposits with the banks increases. However; in every subsequent round the cash reserves diminishes. The process comes to an end when the total cash reserves (aggregate of cash reserves from the subsequent rounds) become equal to the initial deposits of Rs.1,000 that was initially held by the banks.)
Second Part:
(Primary Deficit is Fiscal Deficit net of Interest Payment. It is the difference between Fiscal Deficit and Interest payment. Revenue deficit is the excess of revenue expenditure over revenue receipts. It indicates the Borrowing requirements of the government for the purpose other than interest payment.)
Explanation:
Credit creation is the most important 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 from time to time.
The process of credit creation by commercial banks is explained as follows: (with the help of an example).
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 with Rs. 9000. Then B pays to C, to whom he owes Rs. 9000, by way of cheque to settle his dues with C.
C now deposits the cheque of Rs. 9000 given by B 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. That 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. This results in net decrease in money stock