1) The entire commercial banking system is one unit and is termed as ‘Banks’.
2) All receipts and payments in the economy are routed through the banks (i.e. receipts are deposited and payments are made through cheques)
The money (or deposit or credit) creation by the commercial banks is determined by:-
- The amount of initial deposit(b) Legal Reserve Ratio (LRR).
CRR is fixed by the Central Bank of the country. Higher the CRR, lower will be the credit creation and vice-versa.
Suppose the initial deposit is Rs. 1000 and LRR is 20%.
|Deposits (Rs.)||Cash Reserves (LRR = 20 %)||Loans (Rs. )|
The banks will keep 20 % of initial deposit i.e. Rs. 200 (1000 x 0.20 = 200) as reserve and lend the remaining Rs. 800 (1000-200). Those who borrow will spend this money. It is assumed that Rs. 800 comes back to the banks. This raises total deposits to Rs. 1800. Banks again keep 20 % of 800 i.e. Rs.160 (800 x 0.20 = 160) as reserve and lend the remaining Rs. 640 (800-160). This process will go on. Deposits go on increasing @ 80 % of the last deposit. The number of times, the total deposits will become, is determined by the deposit or money multiplier. Deposit creation comes to an end when total cash reserves becomes equal to the initial deposit.
Money Multiplier =1/LRR =1/0.2 =100/2 = 5 times
Total Deposit = Initial Deposit x Money Multiplier = 1000 x 5 = Rs. 5000
Total LRR = Total Deposit x 20% = 5000 x 20% = 1000 OR Amount of initial deposit i.e. 1000
Total Loans = Total Deposit x 80% = 5000 x 80% = 4000 OR Total Deposits – Total LRR = 5000 – 1000 = 4000