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Question : 11
Total: 18
Explain the process of credit creation by commercial banks.
Solution:
The process of credit creation by commercial bank can be easily understood by taking an example. Suppose a person, say X, deposits ₹ 2000, with a bank and the LRR is 10 % which means the bank keeps only the minimum required ₹ 200 as cash reserve. The bank can use remaining amount ₹ 1800 ( = 2000 − 200 ) for giving loan to someone. The bank lends ₹ 1800 to, say F , for this purpose and an account is opened in the name of Y and the amount is credited in his account. This is the first round of credit creation in the form of secondary deposit (₹ 1800) which equals 90 % of the initial deposit. Now again from the deposit of Y, bank keeps 10 % or LRR i.e. 180 and remaining ₹ 1620 is advanced to, say Z . The bank get, new demand deposit. This is the second round of credit creation till secondary deposit becomes zero. In the end, volume of total credit created it becomes multiple of initial deposit. The quantitative outcome is called money multiplier. In short, money (or credit) creation by commercial banks depends on two factors (i) amount of initial deposit and (ii) LRR. Symbolically :
Total credit creation = Initial deposit×
Total credit creation = Initial deposit
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