Write the story of gold smith Lala on the process of deposit and loan (credit) creation by commercial banks.

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Q. Write the story of gold smith Lala on the process of deposit and loan (credit) creation by commercial banks.

Karnataka PUCKarnataka 2nd PUC Commerce Board 2020Subjective· 6mImportance★★★★★

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Concept understanding — Money Multiplier Determinants

The Money Multiplier: From a ₹100 Note to a River of Credit

Imagine you find a crisp ₹100 note on the street. You deposit it in your bank account. What happens next? That ₹100 doesn't just sit in a vault. The bank, keeping only a fraction aside as required by the RBI, lends out the rest — say ₹90. That ₹90 goes to someone who pays a shopkeeper, who deposits it in their bank. That bank again keeps a fraction and lends out, say ₹81. The cycle repeats.

Your single ₹100 note has now created deposits worth ₹100 + ₹90 + ₹81 + … — a total far larger than the original amount. This multiplying effect is the money multiplier in action.

The Precise Meaning

The money multiplier ( $m$ ) tells us the maximum amount of money the banking system can create from each rupee of fresh reserves (like your ₹100 deposit). It is the ratio of the total money supply ( $M$ ) to the monetary base ( $H$ , also called high-powered money — currency held by the public plus reserves of banks).

m = \frac{M}{H}

Where:

$M$ = total money supply (currency with public + demand deposits)
$H$ = high-powered money (currency with public + cash reserves of banks)

What Determines the Multiplier? (The NCERT Story)

The multiplier is not a magic number. It depends on two key behavioural ratios that the NCERT textbook emphasises:

1. The Currency-Deposit Ratio ( $c$ )

This is the proportion of money people prefer to hold as cash rather than in bank deposits.

c = \frac{C}{D}

$C$ = currency held by the public
$D$ = demand deposits with banks

If people trust banks and find digital payments easy, $c$ is low — more money stays in the banking system, and the multiplier is larger. If people panic and hoard cash (like during a bank run), $c$ rises, and the multiplier shrinks.

2. The Reserve-Deposit Ratio ( $r$ )

This is the fraction of deposits banks keep as reserves (both required by RBI and extra as precaution).

r = \frac{R}{D}

$R$ = total reserves of banks (vault cash + RBI deposits)
$D$ = demand deposits

The RBI sets a minimum Cash Reserve Ratio (CRR) — say 4%. If banks keep exactly that, $r = 0.04$ . If they keep more (excess reserves), $r$ is higher.

The Formula That Connects Everything

From the definitions, NCERT derives the money multiplier in terms of these two behavioural ratios:

m = \frac{1 + c}{c + r}

Let's see why this makes sense:

The numerator $1 + c$ reflects that total money supply $M = C + D = cD + D = D(1 + c)$
The denominator $c + r$ reflects that high-powered money $H = C + R = cD + rD = D(c + r)$
Dividing: $m = \frac{D(1 + c)}{D(c + r)} = \frac{1 + c}{c + r}$

What This Tells Us (The "Why It Matters")

If $c = 0$ (no cash holding, all money in banks): $m = \frac{1}{r}$ . With a 10% reserve ratio, the multiplier is 10 — each rupee of reserves creates ₹10 of deposits.
If $c$ is large (people prefer cash): the multiplier falls. Cash "leaks" out of the banking system and stops the chain of lending.
If $r$ is large (banks keep more reserves): the multiplier falls. Less money is available to lend.

Watch out

The multiplier is a maximum theoretical value. In reality, banks may not lend all excess reserves, and borrowers may not spend all borrowed money immediately. The actual multiplier is usually smaller.

A Simple Numerical Example (NCERT Style)

Suppose:

$c = 0.2$ (people hold ₹20 cash for every ₹100 in deposits)
$r = 0.1$ (banks keep 10% of deposits as reserves)

Then:

$m = \frac{1 + 0.2}{0.2 + 0.1} = \frac{1.2}{0.3} = 4$ …

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The goldsmith Lala story shows how banks create credit by lending out most deposits while keeping a small reserve.

The story of goldsmith Lala: In earlier times people kept their gold with a trusted goldsmith, Lala, for safe custody. In return Lala gave them a paper receipt. Over time these receipts themselves began to be accepted in payment, because anyone holding a receipt could claim the gold from Lala.

Lala soon noticed that all depositors never came to withdraw their gold at the same time — on any day only a small fraction was demanded. So he realised he could safely lend out most of the gold lying idle with him, charging interest, while keeping only a small portion as reserve to meet daily withdrawals. He issued fresh receipts to borrowers too.

As a result, the total value of receipts (which now acted as money) became many times larger than the actual gold Lala held. This is exactly how a modern commercial bank works:

Deposits are like the gold kept with Lala.
The bank keeps only a fraction as cash reserve and lends out the rest. …

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Same / Similar Concept — real previous-year questions on the same or a closely similar concept, not this exact question.

Showing the 12 most recent of 28 on this concept.

CBSE 2026Set 58/1/11 markMCQ
$Q. “In the Indian Banking System, the Statutory Liquidity Ratio (SLR) plays a vital role in controlling the credit creation capacity of the Commercial Banks, as it __________.” (Choose the correct option to fill in the blank) (A) ensures that all the deposits are converted into liquid assets. (B) requires banks to maintain a percentage of deposits in the form of liquid assets. (C) sets the maximum interest rate which the banks can charge on loans. (D) promote banks from lending beyond a specific proportion of their total reserves.$
›Reveal solutionSolution

SLR mandates that commercial banks hold a fraction of their deposits as liquid assets (cash, gold, government securities), thereby reducing the funds available for lending and constraining credit creation. The answer is (B).

The Statutory Liquidity Ratio is one of the Reserve Bank of India's key monetary policy instruments to regulate how much money commercial banks can pump into the economy through loans. To understand why it controls credit creation, we need to see what happens to a bank's balance sheet when it accepts deposits.

When you deposit ₹100 in a bank, that bank does not simply lock the money away. It wants to lend most of it out to earn interest income. But the RBI imposes two constraints: the Cash Reserve Ratio (CRR), which requires the bank to park a percentage with the RBI itself, and the SLR, which requires the bank to hold a percentage in liquid assets—cash in hand, gold, or approved government securities. These liquid assets remain with the bank (unlike CRR, which leaves the bank's vault), but they cannot be lent to customers.

Suppose the SLR is 18% and you deposit ₹100. The bank must immediately set aside ₹18 in the form of liquid assets. Only the remaining ₹82 (minus any CRR obligation) is available for lending. When the bank lends ₹82, that money re-enters the banking system as a fresh deposit elsewhere, and the cycle repeats—but each time, SLR shaves off another slice. The higher the SLR, the smaller the money multiplier, and the less credit the banking system can create in total.

Now let's evaluate each option:

(A) claims SLR ensures all deposits are converted into liquid assets. This is plainly wrong—if all deposits became liquid assets, banks could never lend, and credit creation would collapse entirely. SLR mandates only a fraction, not the whole.

(B) states that SLR requires banks to maintain a percentage of deposits in the form of liquid assets. This is the textbook definition. It directly explains the mechanism: by locking up a portion of deposits, SLR reduces lendable funds and thus controls credit creation.

(C) suggests SLR sets the maximum interest rate on loans. Interest-rate ceilings are a separate regulatory tool (and rarely used in modern India); SLR has nothing to do with pricing loans—it is a quantity control on reserves, not a price control on credit. …
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CBSE 2026Set MARCH1 markMCQ
$Q. Equation of money multiplier is$
(a) Cash Reserve Ratio × 100
(b) 1 / Cash Reserve Ratio
(c) 100 / Cash Reserve Ratio
(d) Cash Reserve Ratio / 100
›Reveal solutionSolution

The money multiplier equals the reciprocal of the cash reserve ratio, so the answer is (b).

…

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CBSE 2026Set ANNUAL1 markMCQ
$Q. The rate determined by the Central Bank is A) Repo Rate B) Reverse Repo Rate C) Bank Rate D) All of the above$
›Reveal solutionSolution

The central bank determines the repo rate, reverse repo rate and bank rate alike, so the answer is D.

All three are quantitative/price instruments the central bank (RBI) uses to control the cost and availability of credit: the repo rate is the rate at which the RBI lends short-term to commercial banks against securities, the reverse repo rate is the rate at which it absorbs their surplus funds, and the bank rate is …

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CBSE 2026Set ANNUAL1 markMCQ
$Q. Decrease in Cash Reserve Ratio will lead to$
(a) fall in aggregate demand
(b) rise in aggregate demand
(c) no change in aggregate demand
(d) fall in general price level
›Reveal solutionSolution

A decrease in CRR expands credit and raises aggregate demand, so the answer is (b).

The Cash Reserve Ratio (CRR) is the fraction of deposits banks must keep with the central bank. When the CRR is decreased, banks are left with more funds to lend, so credit creation and the money supply increase. Greater availability of cheaper credit raises investment and consumption spend …

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CBSE 2026Set ANNUAL1 markMCQ
$Q. If mpc=0.5 then multiplier (K) will be :$
(a) 1/2
(b) 1
(c) 2
(d) 0
(a) 1/2
(b) 1
(c) 2
(d) 0
›Reveal solutionSolution

K = 1/(1 − MPC) = 1/0.5 = 2.

The investment/income multiplier formula is K = 1/(1 − MPC), which also equals 1/MPS since MPC + MPS = 1. Substituting MPC = 0.5: K = 1/(1 − 0.5) = 1/0.5 = 2. This means any initial change in investment (or any autonomous spending) gets multiplied exactly TWO times over, as it works through successive …

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CBSE 2025Set 58/6/11 markMCQ
$Q. If the total credit created by the banks is ₹ 500 and Reserve Ratio is 20%, the value of primary deposits would be __________. (Choose the correct option to fill in the blank) (A) ₹ 200 (B) ₹ 300 (C) ₹ 100 (D) ₹ 500$
›Reveal solutionSolution

The banking system's ability to create credit is determined by the initial primary deposits and the money multiplier, which is inversely related to the reserve ratio. Given the total credit created and the reserve ratio, the primary deposits are calculated to be ₹ 100.

Banks play a crucial role in an economy by facilitating transactions and, more importantly, by creating credit. This credit creation process is how the initial deposits made by the public are multiplied throughout the banking system, leading to a larger supply of money in the economy. The foundation of this process lies in what are called "primary deposits" – the initial cash or cheques deposited by individuals or firms into their bank accounts.

When a bank receives a primary deposit, it does not keep the entire amount as cash. Instead, it is legally required to hold a certain fraction of these deposits as reserves, known as the Reserve Ratio (RR). This ratio is mandated by the central bank (like the RBI in India) to ensure banks maintain liquidity and to control the overall money supply. The remaining portion of the deposit, after setting aside the reserves, is available for the bank to lend out.

When a bank lends money, the borrower typically deposits this loan into their own account, often in another bank. This new deposit then becomes a primary deposit for that second bank, which again sets aside a portion as reserves and lends out the rest. This cycle continues, with each subsequent loan becoming a deposit in another bank, leading to a chain reaction of credit creation. The total amount of credit created by the banking system is a multiple of the initial primary deposit, and this multiple is known as the money multiplier (or credit multiplier).
$m$
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CBSE 2025Set ANNUAL1 markMCQ
$Q. Commercial banks create credit by (A) advancing loans (B) purchasing securities (C) both (A) and (B) (D) none of these$
›Reveal solutionSolution

Banks create credit through both loans and security purchases, so the answer is (C).

Credit creation is the process by which banks expand demand deposits far beyond their initial cash reserves. When a bank (A) advances a loan, it does not hand out cash but opens a deposit account for the borrower, creating new money; and when it (B) purchases securities, it pays by crediting the seller's deposit account, again creating deposits. Both actions create derivative deposits, so credit is …

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CBSE 2025Set ANNUAL1 markMCQ
$Q. Central bank controls credit through (A) bank rate (B) open market operations (C) CRR (D) all of these$
›Reveal solutionSolution

The central bank uses bank rate, OMO and CRR together, so the answer is (D) all of these.

Among the central bank's quantitative methods of credit control are: (A) the bank rate — the rate at which it lends to commercial banks; raising it makes credit costlier; (B) open market operations — buying/selling government securities to inject or withdraw liquidity; and (C) the cash reserve ratio (CRR) — the fraction of deposits banks must keep with the central bank; raising it sh …

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CBSE 2025Set ANNUAL1 markMCQ
$Q. Which of the following is included in the qualitative method of controlling credit? (A) Change in marginal requirement of loans (B) Credit rationing (C) Direct action (D) All of these$
›Reveal solutionSolution

All three are qualitative credit-control tools, so the answer is (D) All of these.

The central bank's credit-control methods are quantitative (bank rate, OMO, CRR — affecting total credit) and qualitative/selective (affecting the use and distribution of credit). Qualitative methods include (A) changing the margin requirement on loans against securities, (B) credit rationing — limiting credit to particular sectors, and (C) direct action against banks that violate guidelines (along with moral suasi …

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CBSE 2025Set ANNUAL1 mark
$Q. Find the increase in income when increase in investment is Rs. 10 crores and the value of multiplier is 2.5.$
›Reveal solutionSolution

Using the investment multiplier formula, change in Y = k x change in I, with k = 2.5 and change in I = Rs. 10 crore, the increase in income works out to Rs. 25 crore.

The investment multiplier (k) measures how many times a given increase in investment leads to a multiple increase in national income, i.e., k = change in Y / change in I, so change in Y = k x change in I.

Given:

change in I (increase in investment) = Rs. 10 crore

k (multiplier) = 2.5

…

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CBSE 2025Set ANNUAL1 mark
$Q. OR (Question 6 alternative) Given CRR = 20% and Initial deposits = Rs. 5,000 crores. Calculate credit creation by the banks.$
›Reveal solutionSolution

With CRR = 20% and an initial deposit of Rs. 5,000 crore, total credit created by the banking system = Rs. 25,000 crore.

Commercial banks must keep a fixed fraction of every deposit as the Cash Reserve Ratio (CRR) with the RBI and can lend out the rest. When that lent-out amount is spent and re-deposited elsewhere in the banking system, the process repeats — this is the basis of multiple credit/deposit creation. The total deposits (credit) the banking system can create from an initial deposit is given by the money (deposit) multiplier:

Total Credit Creation = Initial Deposit × (1 / CRR)

Here, CRR = 20% = 0.20, so the multiplier = 1/0.20 = 5.

Total Credit Creation = Rs. 5,000 crore × 5 = Rs. 25,000 crore

…

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CBSE 2025Set ANNUAL1 markMCQ
$Q. Banks are able to create credit many times more than the initial deposit through$
(a) secondary deposit
(b) advancing loans
(c) accepting deposits
(d) providing overdraft facility
›Reveal solutionSolution

Commercial banks create credit many times the size of the original (primary) deposit through the repeated process of advancing loans out of the deposits they hold, since each loan re-enters the banking system as a fresh deposit that is partly re-lent again.

When a bank receives a primary deposit, it is legally required to keep only a fraction of it — the Legal Reserve Ratio (LRR) — as cash reserve, and is free to lend out the remainder. This act of advancing loans is the actual engine of credit creation, because the loan amount does not disappear from the banking system: the borrower typically spends it, and it is redeposited (by the person who receives it) as a secondary deposit in some bank. That bank, in turn, keeps a fraction as reserve and lends out the rest, which again returns as a further deposit, and so the process repeats.

A simple numerical illustration (LRR = 20%):

Round Deposit (₹) Reserve kept (20%) Loan advanced (80%)
1 (primary) 1,000 200 800
2 800 160 640
3 640 128 512
... ... ... ...
…

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Round	Deposit (₹)	Reserve kept (20%)	Loan advanced (80%)
1 (primary)	1,000	200	800
2	800	160	640
3	640	128	512
...	...	...	...
…

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Q.Write the story of gold smith Lala on the process of deposit and loan (credit) creation by commercial banks.

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