"An increase in the credit creation capacity of commercial banks has a direct impact on the money supply in an economy." Discuss the given statement.

Question

Accepted Answer

The statement is correct. Credit creation capacity of commercial banks directly impacts money supply.

Explanation:
1. Commercial banks create credit through lending
2. Credit creation process expands money supply
3. More credit creation means more money in circulation
4. Money supply increases with credit expansion

Mechanism:
1. Banks receive deposits
2. Keep fraction as reserves
3. Lend the remaining
4. Loans create new deposits
5. Process continues
6. Money supply expands

Example:
Initial deposit = Rs. 1,000 crore
Reserve ratio = 20%
Money multiplier = 5
Total credit created = Rs. 5,000 crore
Money supply increases by Rs. 4,000 crore (additional credit)

Thus, credit creation capacity directly determines money supply in the economy.