Explain the 'Government's Bank' function of the central bank. Using a hypothetical numerical example, explain the effect of rise in Reserve Ratio on credit creation by the commercial banks.

Question

Accepted Answer

Government's Bank function of Central Bank:

1. Accepts government deposits
2. Makes payments on behalf of government
3. Manages government securities
4. Provides short-term loans to government
5. Advises government on financial matters

Effect of rise in Reserve Ratio on credit creation:

Numerical Example:
Initial Deposits = Rs. 1,000 crore
Reserve Ratio = 10%

Before increase:
Money Multiplier = 1/0.10 = 10
Total Credit = 1000 × 10 = Rs. 10,000 crore

After increase to 20%:
Money Multiplier = 1/0.20 = 5
Total Credit = 1000 × 5 = Rs. 5,000 crore

Impact: Credit creation capacity reduces by 50% when Reserve Ratio doubles.