what is credit creation?
Answers
Explanation:
The banks have the power to expand or contract demand deposits. This power is called credit creation. It is an important function of the commercial banks.
ILLUSTRATION
For simplicity sake, assume there is a single banking system in the economy. Let the lehal reserve ratio be 20% and there is a fresh deposit of 1000. As required the bank keep 20% that is 200 as cash reserve. Suppose the bank lend the remaining 800, those who borrow use this money for making payments. As assumed those who recieve payments put the money back into the bank. This is the first round creation of deposits.
Borrowers will use the deposits to meet their obligation to their debtors, by paying them cheques drawn on bank. Recipients or debtors of these cheques will deposit the same in thier respective accounts. Thus the bank gets new deposits. They keep 20% of these deposits, i.e, and Rs.160 as cash reserve and lend the remaining Rs.640. ThIs is the second round creation of deposits.
This again creates new deposits of Rs.640 with the bank. Keeping its 20%, the remainder can again be given as loans to other persons. Thus, this process would continue till all excess reserves are exhausted. The money goes on multiplying in this way, and ultimately total money creation is Rs. 5000.
The total credit creation is always equal to the primary deposits multiplied by the reverse of the cash reserve ratio.
Total credit creation = primary deposits x 1/ cash reserve ratio
= 1000 x 1/ 20%
=Rs.5000
In this way banks can give loans many times over and above their cash deposits. That is why banks are called credit creation industries.
Answer:
Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, most of the money supply is in the form of bank deposits.
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