Question

. With initial deposit of rs. 10000 and legal reserve ratio =20%, explain the process of credit creation
by commercial banks in economy.
​

Answer 1

Credit money creation starts when the commercial banks initiate the lending process.

• People deposit into personal bank accounts. Commercial banks are mandated by the central bank to retain a part of total deposits as cash reserves.
• Banks lend the general public a portion of their overall deposits in the form of credit, loans, and advances. It is the second-largest share of total deposits responsible for credit formation.
• When banks lend money, credit money grows. Banks are able to generate credit money several times the initial deposits because of this continuous operation.

1. Since LRR is 20% banks will maintain a similar amount as cash reserves Thus, they will retain 20% of the deposits received as reserves.
2. Thus, Rs. 10,000 are initial deposits. Money kept as a reserve is 2000. Loan amount is the difference of the two which is 8,000.
3. Cash spent by borrowers comes back as deposits. Thus, there is an increment in DD's. The total deposit will be the sum which is 18,000.
4. Now from 8000, 20% which is 1600 will be kept as a reserve and the difference 6400 will be given.