Using a suitable numerical example, explain the credit creation process of the banking system, in a hypothetical economy.

Question

Accepted Answer

Credit Creation Process:

Numerical Example:
Initial Deposit = Rs. 1,000 crore
Reserve Ratio (LRR) = 20%

Round 1:
Bank receives deposit of Rs. 1,000 crore
Keeps 20% (Rs. 200 crore) as reserve
Lends Rs. 800 crore

Round 2:
Rs. 800 crore deposited back in banking system
Bank keeps 20% (Rs. 160 crore) as reserve
Lends Rs. 640 crore

Round 3:
Rs. 640 crore deposited back
Bank keeps 20% (Rs. 128 crore) as reserve
Lends Rs. 512 crore

...continuing this process:

Total Deposits Created = Initial Deposit × Money Multiplier
Money Multiplier = 1/LRR = 1/0.20 = 5
Total Deposits = 1,000 × 5 = Rs. 5,000 crore
Total Credit Created = Total Deposits - Initial Deposits = 5,000 - 1,000 = Rs. 4,000 crore