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Process of Credit Creation

Banks engage in credit creation by lending out most of the deposits they receive from customers while keeping only a small reserve required by law. When a bank makes a loan by crediting the borrower's account, it creates new deposits, which can then be lent out again by the bank, leading to multiple expansions of the original deposit. The money multiplier formula shows that for a reserve requirement of 20%, an initial $100 deposit could expand the total money supply to $500 through repeated lending and deposit creation by commercial banks.

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Nahidul Islam IU
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84 views1 page

Process of Credit Creation

Banks engage in credit creation by lending out most of the deposits they receive from customers while keeping only a small reserve required by law. When a bank makes a loan by crediting the borrower's account, it creates new deposits, which can then be lent out again by the bank, leading to multiple expansions of the original deposit. The money multiplier formula shows that for a reserve requirement of 20%, an initial $100 deposit could expand the total money supply to $500 through repeated lending and deposit creation by commercial banks.

Uploaded by

Nahidul Islam IU
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Process of credit creation

One of the important functions of commercial bank is the creation of credit. Credit creation is the
multiple expansions of banks demand deposits. It is an open secret now that banks advance a
major portion of their deposits to the borrowers and keep smaller parts of deposits to the
customers on demand.
Formula:
The money multiplier, m, is the inverse of the reserve requirement, R
m=1/R
For example, with the reserve ratio of 20 percent, this reserve ratio, R, can also be expressed as a
fraction:
R=1/5
So then the money multiplier, m, will be calculated as:
m=1/(1/5)=5
This number is multiplied by the initial deposit to show the maximum amount of money it can be
expanded to.
Bank credit means bank loans and advances. A bank keeps a certain proportion of its deposits as
minimum reserve for meeting the demand of the depositors and lends out the remaining excess
reserve to earn income. The bank loan is not paid directly to the borrower but is only credited hi
his account. Every bank loan creates an equivalent deposit in the bank. Thus, credit creation
means multiple expansions of bank deposits. The word 'creation' refers to the ability of the bank
to expand deposits as a multiple of its reserves.

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