‘Reserve Ratio and Credit Creation are inversely related.’ Do you agree with the given statement? Justify your answer with a suitable numerical example.
Answer:
Yes, there exists an inverse relation between Reserve Ratio and Credit Creation in the economy.
We know that:
Money Multiplier = 1/𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑎𝑡𝑖𝑜
Credit Creation = Initial Deposits x Money Multiplier
Assuming that the value of initial deposits is ₹ 10,000 crore. (All figure in ₹ crore)
| Reserve Ratio | Money Multiplier | Initial Deposits |
Credit Creation (Initial Deposits x Money Multiplier) |
| 10% |
1/0.1 = 10 |
10,000 | 1,00,000 |
| 25% |
1/0.25 = 4 |
10,000 | 40,000 |
From the above calculation, we can conclude that higher the reserve Ratio, lesser credit will be created by Commercial Banks in the economy.