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 banks with numerical example as per the syllabus of Economics (Macroeconomics) Class 12 CBSE Board?

I have explained this topic in detail

See, Commercial Bank has the authority to offer borrowings to the general public. The lent amount works as money. As this amount is used by the borrower to pay off his liabilities or to meet his expenses.

In short, the commercial bank creates money by lending money out of deposits.

Lets understand this whole process from start to finish.

Read Here:- Syllabus of Money and Banking Chapter class 12 (2021-22)

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

It is one of the most important activities done by commercial banks. Through the process of money creation commercial banks 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.

The commercial bank accepts deposits. The money of such deposits is used by commercial banks to offer loans to the general public.

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

Such bank deposits also function as money. Because the money deposited can be used to pay off any liabilities or to meet expenses. This is how a bank creates money.

But this process does not end here. Borrowers make payments to purchase the consumption goods, and in investments. It further adds to the revenue of the seller.

Read Here:- What is Money and its definition

Now as we have already assumed, all receipts are deposited into the banks. The seller deposits all his revenue into the bank accounts with commercial banks.

These deposits are new deposits for bank. Bank further uses 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 Ratio) fixed by the Central Bank.

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

Let’s 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.

Read Here:- What is Supply of Money, its Definition and components

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

Let’s now understand the whole process of money (credit) creation by commercial banks with a simple example.

The money (credit) creation depends on two factors. Initial Deposit and LRR.

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, the bank is required to keep ₹ 100 as reserves and is free to offer ₹ 900 as a loan to the general public.

But the bank does not give this loan in cash to the borrower. Rather, it opens a demand deposit account equal to the amount of loan in the name of the borrower.

The borrower is free to withdraw the entire amount out of it.

Suppose, the borrower withdraws the entire amount and spends it on purchasing consumer goods and in investments.

As all transactions are routed through banks. The receivers of the payments, deposit its receipts into their demand deposit accounts.

Read Here:- What is Central Bank, its Definition and Functions

It increases the demand deposits of banks by ₹900.

With this new deposit of ₹ 900. The bank keeps 10% as cash reserves and lends the balance of ₹ 810.

A new demand deposit account equivalent to the amount of loan is created. 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 = 10%)
Initial Deposit1,000900100
Round I90081090
Round II81072981
Round III729656.172.9
Round IV656.1590.4965.61

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 are 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 commercial 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 (credit) creation is also higher, and vice versa.

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

Further Reading:-

Read Here:- How Central bank controls the credit creation by Commercial Bank

Read Here:- Important MCQs of Money and Banking Chapter

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Anurag Pathak
Anurag Pathak

Anurag Pathak is an academic teacher. He has been teaching Accountancy and Economics for CBSE students for the last 18 years. In his guidance, thousands of students have secured good marks in their board exams and legacy is still going on. You can subscribe his youtube channel and can download the Android & ios app for free lectures.

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