Question

Elaborate the process of Credit Creation using a suitable numerical example.

Hint:

Remember — banks create credit by lending out deposits while keeping a fraction as reserves, multiplying money supply in the economy.

Answer 1

Credit creation refers to the process by which commercial banks are able to expand the money supply in an economy on the basis of primary deposits. It is possible due to the fractional reserve system, where banks keep a part of deposits as reserves and lend out the remaining. Numerical Example: Assume the initial deposit in a bank is ₹ 1,000 and the Legal Reserve Ratio (LRR) is 20\%.
Bank keeps ₹ 200 (20\% of ₹ 1,000) as cash reserve.
Lends ₹ 800 to borrowers.
This ₹ 800 is spent and comes back to the banking system as a deposit.
Now, 20\% of ₹ 800 i.e., ₹ 160 is kept as reserve and ₹ 640 is lent out.
This process continues. Total Credit Creation: Using the formula: \[ \text{Total Deposits Created} = \frac{\text{Initial Deposit}}{\text{Cash Reserve Ratio (CRR)}} \] \[ = \frac{1000}{0.20} = ₹ 5,000 \] So, a primary deposit of ₹ 1,000 leads to total deposits of ₹ 5,000 in the banking system.