if the legal reserve ratio is 20% and initial deposit rs 5,000 explain the process of credit creation by commercial Bank.
Answers
Hey mate!
Your answer:
A central bank is the primary source of money supply in an economy through circulation of currency.
It ensures the availability of currency for meeting the transaction needs of an economy and facilitating various economic activities, such as production, distribution, and consumption.
However, for this purpose, the central bank needs to depend upon the reserves of commercial banks. These reserves of commercial banks are the secondary source of money supply in an economy. The most important function of a commercial bank is the creation of credit.
According to Benham’s, “a bank may receive interest simply by permitting customers to overdraw their accounts or by purchasing securities and paying for them with its own cheques, thus increasing the total bank deposits.”
Let us learn the process of credit creation by commercial banks with the help of an example.
Suppose you deposit Rs. 10,000 in a bank A, which is the primary deposit of the bank. The cash reserve requirement of the central bank is 10%. In such a case, bank A would keep Rs. 1000 as reserve with the central bank and would use remaining Rs. 9000 for lending purposes.
The bank lends Rs. 9000 to Mr. X by opening an account in his name, known as demand deposit account. However, this is not actually paid out to Mr. X. The bank has issued a check-book to Mr. X to withdraw money. Now, Mr. X writes a check of Rs. 9000 in favor of Mr. Y to settle his earlier debts.
The check is now deposited by Mr. Y in bank B. Suppose the cash reserve requirement of the central bank for bank B is 5%. Thus, Rs. 450 (5% of 9000) will be kept as reserve and the remaining balance, which is Rs. 8550, would be used for lending purposes by bank B.
- From Table-1, it can be seen that deposit of Rs. 10,000 leads to a creation of total deposit of Rs. 50,000 without the involvement of cash.
The process of credit creation can also be learned with the help of following formulae:
Total Credit Creation = Original Deposit * Credit Multiplier Coefficient
Credit multiplier coefficient= 1 / r where r = cash reserve requirement also called as Cash Reserve Ratio (CRR)
Credit multiplier co-efficient = 1/10% = 1/ (10/100) = 10
Total credit created = 10,000 *10 = 100000
If CRR changes to 5%,
Credit multiplier co-efficient = 1/5% = 1/ (5/100) = 20
Total credit creation = 10000 * 20 = 200000
Thus, it can be inferred that lower the CRR, the higher will be the credit creation, whereas higher the CRR, lesser will be the credit creation. With the help of credit creation process, money multiplies in an economy. However, the credit creation process of commercial banks is not free from limitations.
Thus, this process of deposits and credit creation continues till the reserves with commercial banks reduce to zero.
Hope it helps you! ^_^
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.