Process of Credit Creation
We will understand the process of credit creation by commercial banks. In case you missed, then you can revise the concept of Introduction To Money.
Let’s start with the meaning of commercial bank.
What are commercial banks?
A commercial bank is an institution that performs the function of accepting deposits, granting loans, and making an investment with the aim of earning profit.
What is borrowing rate?
The rate at which commercial banks accept deposits is known as the borrowing rate.
What is lending rate?
The rate at which the commercial banks lend money to the customers is known as the lending rate.
What is spread?
The difference between the lending rate and the borrowing rate is known as the spread.
Spread = Lending rate – Borrowing rate
Process of credit creation by commercial banks
The deposits held by banks are used for giving loans. However, banks can not use whole deposits for lending.
It is legally compulsory for the bank to keep a certain minimum fraction of the deposit as a reserve. This is known as Cash Reserve Ratio (CRR) or Legal Reserve Ratio (LRR).
Banks only keep a fraction of deposits as cash reserve because of their experience banks have observed:
- All depositors do not approach the bank for withdrawal of money at the same time.
- There is a constant flow of new deposits into the banks.
- Suppose initial deposits in the bank are Rupees 1000 and CRR is 20%.
- Banks are required to keep Rupees 200 as cash reserve and are free to lend Rupees 800.
- Suppose they lend Rupees 800 to the borrower as a loan, who used it for making payments.
- As all the transactions are routed through banks, the money spent by the borrower comes bank into the bank in the form of deposit accounts of those who have received this payment.
- This will increase the demand deposits of the bank by Rupees 800.
- With a new deposit of Rupees 800, banks again keep 20% as CRR and lend the balance of Rupees 640 ( 800 x 20/100 is CRR and remaining is available for making payment) to the borrowers for making their payments.
- This process keeps on repeating until the total cash reserve becomes equal to the initial reserves.
The money multiplier or deposit multiplier is the same. It measures the amount of money that the banks are able to create in the form of deposits with every unit of money that it keeps as a reserve.
It is calculate as
Money Multiplier (MM or K) = 1/ CRR times
The formula for total deposit creation = Initial Deposit x Money Multiplier
Try calculating the total deposit created if the initial deposit is Rupees 1000 and the cash reserve ratio is 10%
Solution. Money Multiplier = 1/CRR times
MM = 1/10% times
K = 100/10 times
MM = 10 times
Total deposit = Initial Deposit x Money Multiplier
T.D. = 1000 x 10
Total deposit = Rupees 10000
That’s all for today!
You can read the related post on macroeconomics:
Feel free to join our Facebook group and subscribe to this website to get daily educational content in your mailbox.
Disclosure: Some of the links on the website are adds, meaning at no additional cost to you, I will earn a commission if you click through or make a purchase.