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BANKING AND MONETARY POLICY — Economics STD 12 Commerce — Question

Gujarat BoardEnglish MediumSTD 12 CommerceEconomicsBANKING AND MONETARY POLICY5 Marks
Question
Explain the concept of credit creation.
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Answer

$1.$ Credit creation is the power of commercial banks to expand deposits, through loans, advances and investments.
$2.$ In other words, on the basis of cash deposits of the customers in the bank, the bank makes loans and advances and thus increases the money supply in the market.
$3.$ Banks advance much more than what they collect from people in the form of deposits, thus, creating credit in the economy.
$4.$ The borrower i.e. the person who requires loan is supposed to open an account with the bank when the bank lends him the money from the primary deposits/cash deposits.
$5.$ This account has to be opened so that the borrower can deposit the cheque of the loan $($the amount that he has borrowed$).$ When the borrower deposits the loan money $($derived deposits$)$ in the account, the bank can create another loan account for third person on this derived deposit.
$6.$ Thus, bank creates several deposits from primary deposits.
$7.$ From every deposit, bank keeps a certain proportionate $($cash reserves$)$ money from the full deposit and can lend only remaining money.
$8.$ Credit creation $=$ Primary deposit $(1/$cash reserve ratio$)$
Example:
Primary deposit/Cash deposit of Bank $= ₹ 1,000$
Cash Reserve Ratio $= 20 \%$
Thus, bank can create credit up to$: (1,000 \times 1/20\%) = ₹ 5,000$
Thus, the bank can create money supply of $₹ 5,000$ from primary deposit of $₹ 1,000$ and thus, creating credit of $₹ 4,000$ in the economy
In the following table, we have net deposits of Bank $A, B, C$ and other banks respectively i.e. the amount credited in the account of the borrower (loan amount) and the cash reserve ratio to be maintained is $20\%$. New loan is the amount of loan that is actually given to the borrower
Bank $\text { Net deposits }$ Required
reserves $(20 \%)$		 $\text { New loan }$
$A$ $1000$ $200$ $800$
$B$ $800$ $160$ $640$
$C$ $640$ $128$ $512$
$-$ $-$ $-$ $-$
Other banks $2048$ $409$ $1639$
Total $5000$ $1000$ $4000$
Note: Here, the loan amount is calculated by $–$ Net deposit $– ($Net deposit cash reserve ratio $(20\%))$

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