Q.What is meant by credit creation? Explain how commercial banks create credit.

Credit creation is the process by which the banking system as a whole multiplies deposits far beyond the cash originally paid in.

Meaning. Credit creation is the process by which the commercial banking system, taken as a whole, multiplies the community's deposits far beyond the amount of cash originally deposited. Through it the banking system, in effect, manufactures money.

How banks create credit. A banker learns from experience that not all depositors withdraw their money at once — on any day, withdrawals are largely offset by fresh deposits — so a bank needs to keep only a fraction of its deposits as cash reserve and can lend the rest. The crucial point is that when a bank grants a loan it does not usually pay cash; it opens a deposit account in the borrower's name. Every loan therefore creates a new deposit. When the borrower spends that money and the recipient banks it in another bank, that second bank keeps a fraction as reserve and lends the rest, creating yet another deposit — and so on. A single primary deposit thus ripples through the whole system, creating a chain of derivative deposits many times larger than the original.

• A primary deposit is the cash actually deposited by a customer.
• A derivative deposit is the deposit the bank creates when it grants a loan. …

The biggest misconception is that a single bank creates credit out of nothing; it is the banking system as a whole that multiplies deposits, one bank's loan becoming another bank's deposit. Also, cr …