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Notes - Unit 2 - Money and Banking

Commercial banks create money through the process of credit creation. When a bank receives deposits, it is required by law to keep a portion as reserves while lending out the rest. Each round of lending allows more deposits to be created, with the total credit creation determined by the initial deposits and legal reserve ratio. For an initial deposit of Rs. 10,000 and a 20% reserve ratio, total deposits created would be Rs. 50,000 through 5 rounds of lending. The money multiplier of 5 means the initial deposits can increase total deposits by 5 times.

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285 views3 pages

Notes - Unit 2 - Money and Banking

Commercial banks create money through the process of credit creation. When a bank receives deposits, it is required by law to keep a portion as reserves while lending out the rest. Each round of lending allows more deposits to be created, with the total credit creation determined by the initial deposits and legal reserve ratio. For an initial deposit of Rs. 10,000 and a 20% reserve ratio, total deposits created would be Rs. 50,000 through 5 rounds of lending. The money multiplier of 5 means the initial deposits can increase total deposits by 5 times.

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CBSE Grade 12

Notes: Unit 2: Money and Banking

Sub: Economics

1. The process of credit creation by commercial banks.


- Commercial banks receive deposits from public. The depositors are free to withdraw, in
part or in full, their deposit amounts by writing cheques. The banks use the money in these
deposits to give loans. These functions of the commercial banking system are the basis of
money creation. Note that money creation is also called ‘deposit creation’ or ‘credit
creation.’
Commercial banks cannot use the total deposits for giving loans. It is legally compulsory for
the banks to keep a certain minimum fraction of net total demand deposits as legal reserves.
The fraction is called ‘Legal Reserve Ratio.’
How much are the deposits created is determined by primary deposits and Legal Reserve
Ratio. Primary deposits refer to initial deposits with the commercial banks.
Given the amount of primary deposits and LRR, total deposits creation will be:
1
Total credit creation = Initial Deposits X
𝐿𝑅𝑅
Money creation is a process by which a commercial bank creates total deposits number of
times.
Assumptions:
- There is single banking system in the economy.
- All transactions are routed through banks.
Suppose the initial deposit = 10,000, LRR = 20%

Rounds Deposits Loans Reserves


I 10,000 8,000 2,000
II 8,000 6,400 1,600
III 6,400 5,120 1,280
- - -
-
Total 50,000 40,000 10,000

The process of credit creation will come to an end when the total reserves become equal to
the initial deposits.
Total deposits creation (or credit creation or money creation)
= Initial deposits X 1/LRR
= Rs. 10,000 X 1/0.2
= Rs. 50,000

Money Multiplier:
Money multiplier or credit multiplier or deposit multiplier is the number by which total
deposits can increase due to a given change in deposits.
Money Multiplier = 1/LRR
In our example, LRR is 20%, therefore money multiplier
= 1/LRR
=1/0.2
=5
That means the initial deposit will increase by 5 times.

2. Functions of central bank.


a. Authority of currency issue/ Bank of issue:
Central banks possess the exclusive right to manufacture notes in an economy. All the central
banks across the world are involved in issuing notes to the economy. This is one of the most
important functions of the central bank in an economy and due to this the central bank is
also known as the bank of issue.
b. Banker to the Government/ Government’s Bank:
- As the banker to the government, central bank provides a large number of routine banking
functions to the government like maintaining the balances, arranging and managing funds of
the government and so on.
- It gives loan to the government.
- It accepts receipts and makes payments for the government.
- It works as agent of the government in matters of collection of taxes.
- It manages public debt.
- It also acts as a financial advisor to the government.
c. Bankers’ Bank:
- As the banker to the commercial banks, the Central Bank holds surplus cash reserves of
commercial banks.
- It also gives loan to the commercial banks when they are in need of funds.
- The Central Bank also provides a large number of routine banking functions to the
commercial banks, like cheque clearing, remittance etc.
- It also acts as a supervisor and a regulator of the banking system.
d. Lender of last resort:
- When commercial banks need more funds in order to be able to create more credit, they
may go to market for such funds or go to the Central Bank. Central Bank provides them
funds through various instruments.
- Lender of last resort refers to the role of the central bank, of being ready to lend to banks,
especially when a bank is faced with unanticipated serve financial crises, and due to this
central bank is said to be the ‘lender of last resort.’
- If the central bank refuses to extend this this help, there is no option for the bank but to shut
down.
e. Controller of credit:
‘Credit control’ is the most crucial function played by any Central Bank in the modern times.
The primary objective of credit control is to remove causes responsible for instability in price
fluctuations which in turn are related to the supply of money. By controlling credit, the
Central Bank can exercise an effective control over economic activity and mobilise it in the
desired direction.

3. Do you consider a commercial bank ‘creator of money’ in the economy?


- Yes, commercial bank act as a creator of money in the economy. They create credit in the
form of demand deposit related to the loans offered by them. Thus, banks create credit by
advancing loans.

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