Credit Creation by Commercial Bank
A commercial bank is called a dealer of credit.
It can create credit i.e. can expand the monetary base of a country.
It does so not by issuing new money but by its loan operations.
Banks create money on the basis of the cash deposits.
The process of credit creation is that the depositors think they have so much money with banks and borrowers from bank say they have so much money with them.
Summing the two, we find an amount more than the cash deposit.
Suppose a bank receive a sum of ` 1,000 as deposit, keeps with it 20% (` 200) as CRR (cash reserve ratio) and lends and rest.
Depositor will claim he has ` 1,000 and bank borrower too possesses ` 800.
Thus total money supply appears to be ` 1,800 only. It is the credit creation by a single bank.
The above example can be extended to cover the banking system as whole. Suppose ` 800 is deposited to another bank.
This banks base will now expand. It will keep 20% of ` 800 (` 160) as cash reserve and will lend ` 640.
This sum is redeposited to a third bank which keeps 20% of ` 640 (` 128) and grants a loan of ` 512.
This process will continue and the amount of fresh deposit will go on falling.
A time will come when deposited sum will be equal to CRR.
The process will then come to an end.