Credit Creation
By: Naineta MK
12 C
Introduction
Credit creation or money creation is one of the most important
functions of commercial banks. They have the power to multiply
their initial deposits by continuous lending and deposit
accumulation. Thus, they help in increasing the national income of
the country by doing so. Let us understand the process of credit
creation deeply
Credit creation of Commercial
banks
The commercial banks are the second most important sources of
money supply. The money that commercial banks supply is called credit
creation.
The process of ‘Credit Creation’ begins with banks lending money out
of primary deposits. Primary deposits are those deposits which are
deposited in banks.
After maintaining the required reserves, the bank can lend the
remaining portion of primary deposits. Here bank’s lend the money and
the process of credit creation starts.
Two assumptions of the
credit creation process:
->All commercial banks in the country are treated as a
single unit as ‘Banks’.
->There are no cash receipts and payments. ie all the
transactions are routed through banks only.
Credit creation process
Steps Deposits Reserves Loans
I 1000 200 800
II 800 160 640
III 640 128 512
IV 512 102.4 409.6
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-- -- --
5000 4000 1000
Explanation of schedule
In the schedule primary deposits are assumed Rs 1000 and LRR is 20%.
In first step 200 rupees are kept by bank as reserve and remaining 800
rupees can be distributed as loan.
This amount is distributed as credit entry.
It means it will be deposited in bank accounts of borrowers.
Commercial banks will keep again 20% of 800 and remaining amount
can be distributed as loan to borrowers.
This process will continue till reserves are exhausted.
Total money created depends on Legal reserve requirements(LRR). Lower
the LRR, larger would be the expansion of credit. In the above given
example, LRR was 20% and the total money created by primary deposit of
Rs 1000 is Rs 5000 . ie 5 times of the primary deposits. This factor by
which the initial deposits of a bank multiply itself is known as
Credit multiplier or money multiplier. It is inverse of Legal reserve
requirements(LRR). Higher the LRR, less would be the value of money
multiplier and less credit will be created and vice versa.
Money multiplier=1/LRR
Factors affecting Credit creation
1.Primary cash deposits: Larger is the amount of primary deposits
in a bank, more would be the amount of money created by virtue
of credit creation process, as primary deposits serve as the basis
of this process.
2.Legal Reserve Ratio: Higher the LRR, lower would be the lending
capacity of bank and value of credit multiplier. Low LRR allows
bank to lend more fraction of money and thus increases the value
of credit multiplier and consequently the value of total money
created.
3.Policy of the Central bank: The central bank has the powers of
control credit and may encourage or discourage the banks to supply
money in the economy in different situations, by the virtue of its
monetary policy.
Conclusion
Credit creation is crucial for economic growth, allowing
banks to lend more than their deposits. This process
stimulates investment and consumption. However, it
carries risks of over-leverage and financial instability.
Thus, effective regulation is essential to balance the
benefits of credit with the need for economic stability.
Thank You
for your kind patience
