Commercial banks play an important role in ‘credit creation’ in the economy. They have the capacity to generate credit through demand deposits. These demand deposits make more credit than the initial deposits. The process of money creation can be explained by taking an example of a bank XYZ. A depositor deposits Rs 10,000 in his savings account, which will become the demand deposit of the bank.
Based on the assumption that not all customers will turn up the same day to withdraw their deposits, the bank maintains a minimum cash reserve of 10 % of the demand deposits i.e. maintains a reserve of Rs.1000. It lends the remaining amount of Rs 9000 in the form of credit to other customers. This further creates deposits for the bank XYZ. Keeping the minimum cash deposits, the banks again lent the remaining and so on.
With the cash reserve of Rs.1000, the credit creation is worth Rs.10, 000. This is given by the credit multiplier as: Credit multiplier = 1/ CRR = 1/ 10% = 10 The money supply in the economy will increase by the amount (times) of credit multiplier.
