explain the process of credit creation by commercial banks
Commercial banks play the important role of ‘money creator’ in the economy. They have the capacity to generate credit through demand deposits. These demand deposits make credit more than the initial deposits.
The process of money creation can be explained by taking an example of a bank XYZ. A depositor deposits Rs.10,000 in his savings account, which will become the demand deposit of the bank. Based on the assumption that not all customers will turn up at the same day to withdraw their deposits, bank maintains a minimum cash reserve of 10 % of the demand deposits, i.e. Rs.1000. It lends the remaining amount of Rs.9000 in the form of credit to other customers. This further creates deposits for the bank XYZ. With the cash reserve of Rs.1000, the credit creation is worth Rs.10,000. So, the credit multiplier is given by:
Credit multiplier = 1/CRR = 1/10% = 10
The money supply in the economy will increase by the amount (times) of credit multiplier.
1.Let us assume primary deposits in a bank is rs1000.
2.LRR is 20%.
3.total money creation will be 5000.
4.the bank will keep 20% of 1000 lend d remaining amount of 800.
5.borrower will use this money the money will come to the banking system.
6.Now Rs.800 will be deriative deposit,the bank will keep 20% the remaining 640 will lend.
7.640 will be next LRR,bank will keep 20% of 640 in reserve lend out the remaining 512 to borrowers.