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Money Creation by Commercial Banks

Credit creation process, primary vs secondary deposits, money multiplier formula, and numerical examples.

Notes

Money Creation by Commercial Banks

Class 12 Macro Economics — Credit Creation, Money Multiplier, and Numerical Examples

Understanding Money Creation — Key Concepts

Money Creation (Credit Creation)
A key activity of commercial banks allowing them to create credit significantly exceeding initial deposits.

Two Key Assumptions

  1. The entire commercial banking system acts as a single unit ('Banks').
  2. All transactions (receipts and payments) are routed through the banks (payments by cheque, receipts deposited).

Primary Deposits

  • •Cash deposits made by people into various accounts (saving, current, term deposit)
  • •Represent actual savings of the household sector
  • •The original source of funds entering the banking system

Total Demand Deposits = Primary Deposits + Secondary Deposits

Why Only a Fraction of Deposits are Kept as Reserves

Why Not 100% Reserves?

Experience shows that keeping a fraction (e.g., 20%) is sufficient to meet daily withdrawal demands. Banks are legally required to hold a minimum fraction of their deposits as reserves, known as the Legal Reserve Ratio (LRR), Reserve Deposit Ratio, or Reserve Ratio (RR), fixed by the central bank.

100%

Total Deposits

LRR

Reserves (20%)

80%

Available to Lend

The Credit Creation Process — Step by Step

Walk through the rounds of money creation to see how an initial deposit multiplies through the banking system.

Round 0 — Initial Deposit

1/5

Assume initial deposit is ₹1,000 and LRR is 20%.

Banks keep ₹200 (20% of 1,000) as reserve and can lend ₹800.

Credit Creation Table (LRR = 20%)
RoundDeposits (₹)Loans (₹)Cash Reserves (₹)
Initial₹1,000₹800₹200
Round I₹800₹640₹160
Round II₹640₹512₹128
Round III₹512₹410₹102
Round IV₹410₹328₹82
............
Total₹5,000₹4,000₹1,000

Money Multiplier — Formula and Application

The money multiplier determines how much credit the banking system can create from a given reserve base.

Money Multiplier

$$\text{Money Multiplier} = \frac{1}{\text{LRR}}$$

Formulae Collection

Money Multiplier = 1 / LRR
Total Credit Creation = Initial Deposits × Money Multiplier
Total Credit Creation = Initial Deposits × (1 / LRR)
Initial Deposits = Total Deposits / Money Multiplier
Money Multiplier = Total Deposits / Initial Deposits
Total Demand Deposits = Primary + Secondary Deposits

Interactive Calculator

20%
5%50%
Money Multiplier5.00
Total Credit Creation₹5,000

Solved Example

Problem

Calculate total credit creation if initial deposit is ₹1,000 crores and LRR is 12.5%.

Solution

₹8,000 crores (maximum credit banks can create given the LRR)

Connection to National Income

Money Creation and National Income

Money creation by commercial banks increases National Income because banks lend primarily to investors. Increased investment leads to a rise in National Income through the multiplier effect.

Key Takeaways

Key Takeaways

  • Commercial banks create credit through fractional reserve banking — they lend out a portion of deposits while keeping a fraction as reserves (LRR)
  • Primary deposits are actual savings; secondary (derivative) deposits are created when banks grant loans
  • The credit creation process follows a geometric series: Initial Deposit × (1 / LRR) = Total Credit Creation
  • Money Multiplier = 1 / LRR — a higher LRR reduces the multiplier and limits money creation
  • The entire banking system acts as a single unit, and all transactions are routed through banks for the process to work
  • Money creation by banks fuels investment, which increases National Income through the multiplier effect