Credit creation is one of the most important functions of commercial banks. It is the process by which banks create credit (or money) several times more than the cash deposits they receive. Banks do this because they know from experience that not all depositors withdraw their money at the same time. So a bank keeps only a small part of its deposits as cash reserve and lends out the rest. When the borrowed money comes back into the banking system as new deposits, it is lent again ā and in this way the total deposits and loans in the banking system multiply.
Credit creation is the process by which banks create credit many times their cash deposits.
It is a major function of commercial banks.
Primary deposits are cash deposited by customers; secondary deposits are created by loans.
Banks keep a fraction of deposits as reserve (CRR) and lend the rest.
'Loans create deposits' is the basis of credit creation.
Money multiplier = 1 / CRR; total credit = initial deposit Ć (1/CRR).
Lower CRR means more credit creation; higher CRR means less.
Credit creation means the multiple expansion of bank deposits. Commercial banks are able to create deposits (and therefore money) many times more than their original cash reserves.
Two types of deposits are involved:
So, 'loans create deposits' ā this is the basis of credit creation.
Banks keep only a fraction of their deposits as reserve (called the Cash Reserve Ratio or CRR) and lend out the rest. The lent money comes back to the banking system as a fresh deposit, and the process repeats.
Example (with CRR = 10%, i.e., 0.10): ā¢ A person deposits ā¹1,000 (primary deposit). ā¢ The bank keeps 10% (ā¹100) as reserve and lends ā¹900. ā¢ The ā¹900 is spent and returns to a bank as a deposit. That bank keeps ā¹90 and lends ā¹810. ā¢ This continues ā ā¹900, ā¹810, ā¹729 ā¦ and so on. ā¢ The total deposits created = 1000 + 900 + 810 + ā¦ = ā¹10,000.
So an initial deposit of ā¹1,000 has created total deposits of ā¹10,000 ā ten times the original.
Credit multiplier (money multiplier): Total credit created = Initial deposit Ć (1 / CRR) The money multiplier = 1 / CRR.
In the example above, CRR = 0.10, so the multiplier = 1 / 0.10 = 10. An initial deposit of ā¹1,000 created ā¹10,000 of total deposits.
The smaller the CRR, the larger the credit creation, and the larger the CRR, the smaller the credit creation.
Limits to credit creation:
Credit creation is the process by which commercial banks create credit (money) many times more than their original cash deposits. Banks keep only a small part of deposits as reserve and lend out the rest; when the loaned money returns as fresh deposits and is lent again, the total deposits in the banking system multiply.
Primary deposits are the cash that customers deposit in a bank; they simply convert cash into deposits and do not create new money. Secondary (derivative) deposits are created by the bank when it grants a loan ā instead of paying cash, the bank opens a deposit account for the borrower. These secondary deposits increase the money supply, which is the heart of credit creation.
The money multiplier is the number of times the total deposits increase compared with the initial deposit. It equals 1 divided by the Cash Reserve Ratio (CRR). For example, if CRR is 10% (0.10), the multiplier is 1/0.10 = 10, so an initial deposit of ā¹1,000 can create total deposits of ā¹10,000.
Credit creation is limited by the cash reserves available and the CRR set by the central bank, the willingness of people to borrow, the availability of good securities for lending, the cash that the public keeps outside banks (leakage), and the monetary policy of the central bank (the RBI in India).
What is 'Inter-State' Supply in GST?
Learn the exact meaning of Inter-State supply in Indian GST. Understand when the heavy IGST tax is applied and how it differs from Intra-State sales.
What is the Full Form of IRDP? (Govt Scheme)
Learn the full form of IRDP in Economics. Discover the history and massive goals of the Integrated Rural Development Programme to eradicate rural poverty.
What is the Full Form of IRN in GST? (E-Invoicing)
Learn what IRN stands for in Indian taxation. Understand the massive importance of the Invoice Reference Number in the GST E-invoicing system.
What is Knowledge Process Outsourcing (KPO)?
Learn the exact definition of Knowledge Process Outsourcing (KPO). Understand how it massively differs from BPO and why it requires highly educated experts.
Liberalisation, Privatisation, and Globalisation (LPG)
Learn about Liberalisation, Privatisation, and Globalisation (LPG reforms) in India. Understand the 1991 economic reforms, their reasons, and impact on the Indian economy.
Turn this guide into revision flashcards, a practice exam, or an AI-generated podcast ā free, no signup required.