Explain how banks help in the Process of Money Creation and Credit Creation
We know that Banks take Deposits from Public and provide loans or credit to other people with that money
Suppose Banks Receive Deposits of Rs 1,00,000
They cannot give loan of whole Rs 1,00,000
They have to keep a certain amount as Reserve (called Reserve Deposit Ratio or Legal Reserve Ratio)
Suppose Legal Reserve Ratio is 20%
It means Banks have to keep 20,000 with them as Reserve
They can give loan of balance 80,000
Now when bank gives Balance Rs 80,000 as loan
Person who receives this loan money makes a number of expenses with this money
Lets assume He makes expenses of Rs 80,000 with this money as Salary to employee
This Employee will again deposit this Rs 80,000 with bank
Banks will retain Reserve of 20% (Rs80,000*20% = Rs16,000)
They will give loan of balance amount Rs 80,000 - 16,000 = Rs 64,000
Similarly the process continues as shown below
Note
More we go down ,the amount of reserves will diminish
It will soon come a point where Total Reserves will be equal to Initial amount deposited
Initial Amt deposited = Total Reserves = Rs 1,00,000
At this Stage, Total Deposits will be Rs 5,00,000
and Total loans will be Rs 4,00,000
Hence, we can Say that
With Initial Deposits of Rs 1,00,000
Banks are able to generate Deposits of Rs 5,00,000 and Credit of Rs 4,00,000
What is Money Multiplier?
It is the multiple by which initial deposits increase
It is the Ratio of Deposits Created over Initial Deposits
Money Multiplier = Deposits Created/Initial Deposits
Formula for Calculating Money Multiplier
(Without making Table)
Money Multiplier = 1/Legal Reserve Ratio
NC113:C198
Question 8
What is money multiplier?
What determines the value of this multiplier?
View answer
Ans
It is the multiple by which initial deposits increase
It is the Ratio of Deposits Created over Initial Deposits
The value of this multiplier is determined by Legal reserve ratio (LRR)
It is the Ratio of Reserves kept by bank to Total Deposits.
Legal reserve ratio = Total Reserves of Bank
LRR Total Deposits of bank
Money Multiplier = 1/Legal Reserve Ratio
Example
Legal Reserve Ratio was 0.2
So
Money Multiplier = 1/Legal Reserve Ratio
= 1 /0.2
= 1*10/2
= 10/2
= 5
Question 10
Do you consider a commercial bank ‘creator of money’ in the economy?
View answer
Ans
Suppose Banks Receive Deposits of Rs 1,00,000
They cannot give loan of whole Rs 1,00,000
They have to keep a certain amount as Reserve (called Reserve Deposit Ratio or Legal Reserve Ratio)
Suppose Legal Reserve Ratio is 20%
It means Banks have to keep 20,000 with them as Reserve
They can give loan of balance 80,000
Now when bank gives Balance Rs 80,000 as loan
Person who receives this loan money makes a number of expenses with this money
Lets assume He makes expenses of Rs 80,000 with this money as Salary to employee
This Employee will again deposit this Rs 80,000 with bank
Banks will retain Reserve of 20% (Rs80,000*20% = Rs16,000)
They wil give loan of balance amount Rs 80,000 - 16,000 = Rs 64,000
Similarly the process continues as shown below
| Initial Deposit | Reserve | Loan |
| 1,00,000 | 20,000 | 80,000 |
| 80,000 | 16,000 | 64,000 |
| 64,000 | 12,800 | 51,200 |
| … | … | … |
| 5,00,000 | 1,00,000 | 4,00,000 |
Note
More we go down ,the amount of reserves will diminish
It will soon come a point where Total Reserves will be equal to Initial amount deposited
Initial Amt deposited = Total Reserves = Rs 1,00,000
At this Stage, Total Deposits will be Rs 5,00,000
and Total loans will be Rs 4,00,000
Hence, we can Say that
With Initial Deposits of Rs 1,00,000
Banks are able to generate Deposits of Rs 5,00,000 and Credit of Rs 4,00,000
Hence, commercial banks leads to money creation and credit creation in economy
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Question 1
In the following questions, select the correct answers:
Through the process of _____, commercial banks are able to create credit, which is in far excess of the initial deposits.
a. Advancing of Loans
b. Money Creation
c. Credit Creation
d. Accepting Deposits
View answer
Ans
b. Money Creation
c. Credit Creation
Explanation
Money Creation is the process by which initial deposits increase
It is the Ratio of Deposits Created over Initial Deposits
It is also called Credit Creation
The value of this is determined by Legal reserve ratio (LRR)
Money Multiplier = 1/Legal Reserve Ratio
Question 2
Banks create credit:
a. Out of nothing
b. On the basis of their securities
c. On the basis of their total assets
d. On the basis of deposits
View answer
Ans
d. On the basis of deposits
Explanation
Money Creation is the process by which initial deposits increase
It is the Ratio of Deposits Created over Initial Deposits
The value of this is determined by Legal reserve ratio (LRR)
Money Multiplier = 1/Legal Reserve Ratio
Question 3
If the total deposits created by commercial banks is Rs10,000 crores and LRR is 40%,
then amount of initial deposits will be ____.
a. Rs 2000 crores
b. Rs 3000 crores
c. Rs 4000 crores
d. Rs 14000 crores
View answer
Ans
c. Rs 4000 crores
Explanation
LRR = 40% Deposits Created = Rs 10,000 crores
Money Multiplier = 1/Legal Reserve Ratio
Putting value in Eq 1
Money Multiplier = 1/40%
Money Multiplier = 1*100/ 40
Money Multiplier = 1*10/ 4
Money Multiplier = 2.5
Also,
Money Multiplier = Deposits Created/Initial Deposits
Putting value in Eq 2
2.5 = 10,000/ Initial Deposits
Initial Deposits = 10,000/2.5
Initial Deposits = Rs 4000 crores
Question 4
Deposit creation by banks come to an end when:
a. Fresh deposits with banks become zero
b. Legal Reserve Ratio becomes zero
c. Money Multiplier becomes zero
d. Total Cash Reserves becomes equal to Initial Deposits
View answer
Ans
d. Total Cash Reserves becomes equal to Initial Deposits
Question 5
The value of multiplier will be ____, when LRR = 20%.
a. 2
b. 3
c. 4
d. 5
View answer
Ans
d. 5
Explanation
LRR = 20%
Money Multiplier = 1/Legal Reserve Ratio
Money Multiplier = 1/ 20%
Money Multiplier = 1*100/ 20
Money Multiplier = 10/2
Money Multiplier = 5