Process of Money (Credit) Creation by Commercial Bank in Economics class 12

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Are you looking for the Money (credit) creation process by Commercial bank with numerical example as per the syllabus of Economics (Macroeconomics) Class 12 CBSE Board?

I have explain this topic in detail

See, Commercial Bank has the authority to offer borrowings to the general public. In this whole process, it creates secondary deposits and these deposits work as money.

In short, commercial banks creates money by lending money out of primary deposits.

Lets understand this whole process from starts to finish.

Explain the credit creation process by Commercial Bank in Economics Class 12

It is one of the most important activity done by commercial banks. Through the process of money creation commercial banks are are able to create credit, which is far in excess of the initial deposits.

This whole process works under 2 assumptions.

  1. The entire commercial banking system is a one-unit, consists only one bank in the country.
  2. All payments and receipts are routed through banks. All payments are made through cheques and all receipts are deposited in the banks.

It is only the commercial bank which accepts demand deposits. The money of such demand deposits is used by commercial bank to offer loan to general public.

When a bank approved a loan. It does not give cash, a bank deposit is open equal to the amount of loan. Borrower is free to withdraw the whole amount out of it.

Such bank deposits also function like money. This is how bank creates money.

But this process does not end here. Borrower make payment in purchasing the consumption goods and in investments. It further adds to the revenue of the seller.

Now as we have already assumed all receipts are deposited into the banks. Seller deposits all his revenue into the demand deposits accounts with commercial banks.

These deposits are new deposits for banks. Banks further use this money to offer more loans to the general public and thus this process goes on.

But how much a bank can create money or credit? Yes there is a limit.

It depends on the LRR (Legal Reserve Ration) fixed by the Central Bank.

Note;- As per the requirement, Central bank can reduce or increase the LRR.

Lets discuss what LRR is.

It is legally compulsory for the banks to keep a certain minimum fraction of their deposits as reserves. This fraction is called Legal Reserve Ratio. it is fixed by Central Bank.

Why Commercial Bank keeps a fraction of demand deposits as reserves.

There are two assumptions in this regard.

  1. All the depositors do not approach the banks for withdrawal of money at the same time and do not withdraw the entire amount in one go.
  2. There is always a constant flow of new deposits into the banks.

So, to meet the daily demand of withdrawal a certain fraction of demand deposits is kept as a reserve.

Explain the process of credit creation by the commercial bank with the help of a numerical example

Let us now understand the whole process of money (credit) creation by commercial bank with a simple example.

Following are the assumptions.

  1. Initial Deposit is ₹ 1000
  2. LRR is 10%

Suppose, Initial Deposits in banks is ₹ 1000 and LRR is 10%. It implies, bank is required to keep ₹ 100 as reserves and is free to offer ₹ 900 as loan to general public. But bank goes not given this loan in cash to borrower. Rather it open a demand deposit account equal to the amount of loan in the name of borrower. Borrower is free to withdraw the entire amount out of it.

Suppose borrower withdraw the entire amount and spend it in purchasing consumption goods and in investments. As all transactions are routed through banks. The receivers of the payments deposits its receipts into their demand deposits accounts. It increases the demand deposits of banks by ₹900.

With this new deposit of ₹ 900, bank keeps 10% as cash reserves and lend the balance ₹ 810. A new demand deposit account equivalent to the amount of loan is create. Borrowers use these loans for making payments. Which again comes back into the bank accounts of those who received payments. This time bank deposits rise by ₹ 810.

The deposits keep on increasing in each round by 90% of the last round deposits. At the same time, cash reserves also go on increasing, each time by 90% of the last cash reserve. Deposit creation comes to an end when total cash reserves become equal to the initial deposit.

Below is the tabular representation of the whole process.

Deposits (₹)Loan (₹)Cash Reserves (₹)
(LRR = 20%)
Initial Deposit1,000900100
Round I90081090
Round II81072981
Total10,0009,0001,000

As seen in the table, banks are able to create total deposits of ₹ 10000 with the initial deposits of just ₹ 1000. It implies total deposits is 10 times the initial deposit.

How we come to the conclusion this would be 10 times. This figure is calculated through Money Multiplier.

Money Multiplier:-

Money Multiplier refers to the process of creation of credit by the commerical banks, with the help of initial deposits made by the public and legal reserve ratio. It is calculated as

Money Multiplier = 1/LRR

In above example LRR is 10%

Hence Money Multiplier = 1/10% = 10 times.

The conclusion:-

The money creation by the bank solely depends upon the initial deposits and percentage of LRR.

If the initial deposits are higher, money creation is also higher and vice versa.

If the legal reserve ration is less, money creation is higher and vice versa.

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