what is credit creation??????
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Credit creation is a situation in which banks make more loans to consumers and businesses, with the result that the amount of money in circulation increases.
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It is an open secret that the banks do not keep cent per cent reserve against deposits in order to meet the demands of depositors. The bank is not a cloak room where you can keep your currency notes or coins and claim those very notes or coins back when you desire. It is generally understood that money received by the bank is meant to be advanced to others. A depositor has to be content simply with the bank’s promise or undertaking to pay him back whenever he makes a demand.
This bank is able to do with a very small reserve, because all the depositors do not come to withdraw money simultaneously; some withdraw, while others deposit at the same time. The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve. The bank is able to lend money and charge interest without parting with cash. The bank loan creates a deposit or, as we have seen above, it creates a credit for the borrower.
Similarly, the bank buys securities and pays the seller with its own cheque which again is no cash; it is just a promise to pay cash. The cheque is deposited in some bank and a deposit is created or credit is created for the seller of the securities. This is credit creation.
Thus, term ‘credit creation’ implies a situation, to use Benham’s words, when “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.”
Limitations on Credit Creation:
From the account of credit creation given above, it would seem that the banks ‘reap where they have not sown’. They advance loans or buy securities without actually paying cash. But they earn interest on the loans they give, or earn dividends on the securities they purchase, all the same. This is very tempting. They make profits without investing cash. They would, of course, like to make as much profit, like this, as they can.
But they cannot go on expanding credit indefinitely. In their own interest, they have to apply the brake and they do actually apply it, for it is well known that the profits made by the banks are not very high. The overriding limitation arises from the obligation-of the banks to meet the demands of their depositors.
Benham has mentioned three limitations on the powers of the banks to create credit: ;
(i) The total amount of cash in the country;
(ii) The amount of cash which the public wishes to hold; and
(iii) The minimum percentage of cash to deposits which the banks consider safe.
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This bank is able to do with a very small reserve, because all the depositors do not come to withdraw money simultaneously; some withdraw, while others deposit at the same time. The bank is thus enabled to erect a vast superstructure of credit on the basis of a small cash reserve. The bank is able to lend money and charge interest without parting with cash. The bank loan creates a deposit or, as we have seen above, it creates a credit for the borrower.
Similarly, the bank buys securities and pays the seller with its own cheque which again is no cash; it is just a promise to pay cash. The cheque is deposited in some bank and a deposit is created or credit is created for the seller of the securities. This is credit creation.
Thus, term ‘credit creation’ implies a situation, to use Benham’s words, when “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.”
Limitations on Credit Creation:
From the account of credit creation given above, it would seem that the banks ‘reap where they have not sown’. They advance loans or buy securities without actually paying cash. But they earn interest on the loans they give, or earn dividends on the securities they purchase, all the same. This is very tempting. They make profits without investing cash. They would, of course, like to make as much profit, like this, as they can.
But they cannot go on expanding credit indefinitely. In their own interest, they have to apply the brake and they do actually apply it, for it is well known that the profits made by the banks are not very high. The overriding limitation arises from the obligation-of the banks to meet the demands of their depositors.
Benham has mentioned three limitations on the powers of the banks to create credit: ;
(i) The total amount of cash in the country;
(ii) The amount of cash which the public wishes to hold; and
(iii) The minimum percentage of cash to deposits which the banks consider safe.
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