Question

Explain credit creation by banks.

Hint:

The lower the Legal Reserve Ratio (LRR), the higher the credit multiplier, and the greater the ability of banks to create credit.

Answer 1

Step 1: Understanding the Concept:
Credit creation is one of the most important functions of commercial banks. It is the process by which banks multiply an initial deposit into a much larger amount of total deposits, thereby "creating" credit or money in the economy.

Step 2: The Process of Credit Creation:
The process is based on two key assumptions: \begin{enumerate} \item The entire banking system is treated as a single unit. \item All transactions (receipts and payments) are done through banks. \end{enumerate} The credit creation capacity of banks depends on the Legal Reserve Ratio (LRR), which is the fraction of deposits that banks are legally required to keep as reserves (e.g., CRR + SLR).

Step 3: Numerical Example:
Let's assume the LRR is 20% (or 0.2) and there is an initial fresh deposit of Rupees 1,000. \begin{itemize} \item Round 1: A depositor deposits Rupees 1,000. The bank keeps 20% (Rupees 200) as a reserve and can lend out the remaining Rupees 800. \item Round 2: The person who borrows Rupees 800 spends it. The money eventually comes back to the banking system as a new deposit in someone else's account. The bank again keeps 20% of this Rupees 800 (Rupees 160) and lends out the remaining Rupees 640. \item Round 3: This Rupees 640 is spent and comes back as a new deposit. The bank keeps 20% (Rupees 128) and lends out Rupees 512. \item This process continues, with each new loan becoming smaller, until the initial excess reserves of Rupees 800 have been fully converted into required reserves. \end{itemize}

Step 4: The Credit Multiplier:
The total amount of credit created can be calculated using the credit multiplier formula: \[ \text{Credit Multiplier} = \frac{1}{LRR} \] In our example, the multiplier is \(1 / 0.20 = 5\).
Total Deposit Creation = Initial Deposit \(\times\) Credit Multiplier \[ \text{Total Deposits} = 1,000 \times 5 = \text{Rupees 5,000} \] Thus, an initial deposit of Rupees 1,000 leads to a total deposit creation of Rupees 5,000.

Step 5: Final Answer:
Credit creation is the process where commercial banks, based on an initial deposit, are able to generate a much larger volume of total deposits through their lending activities. This capacity is determined by the credit multiplier, which is the reciprocal of the Legal Reserve Ratio.