Read the following statements carefully : Statement 1: Reserve ratio and Credit creation process are inversely

Question 48 of 67

Q. Read the following statements carefully : Statement 1: Reserve ratio and Credit creation process are inversely related. Statement 2: Central Bank of an economy performs the vital function of controlling the credit creation process. In light of the given statements, choose the correct alternative from the following : (A) Statement 1 is true and Statement 2 is false. (B) Statement 1 is false and Statement 2 is true. (C) Both Statements 1 and 2 are true. (D) Both Statements 1 and 2 are false.

Lakshadweep CbseCBSE Class XII Board 2024MCQ· 1mImportance★★★★★

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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 reserve ratio and credit creation are inversely related, and the Central Bank actively controls the credit creation process.

To understand these statements, we first need to grasp the fundamental concepts of credit creation by commercial banks and the role of the Central Bank in managing the economy's money supply.

Commercial banks are not just passive recipients of deposits; they are active creators of credit. When a bank receives a deposit, it doesn't keep the entire amount in its vault. Instead, it is legally required to hold a certain fraction of these deposits as reserves and can lend out the remaining portion. The money lent out eventually finds its way back into the banking system as new deposits, which are then again partially reserved and partially lent, creating a multiplier effect. This process, where an initial deposit leads to a much larger expansion of the money supply, is known as credit creation.

Now, let's examine Statement 1: "Reserve ratio and Credit creation process are inversely related."

The 'reserve ratio' refers to the fraction of deposits that commercial banks are legally required to keep with the Central Bank (Cash Reserve Ratio or CRR) or in liquid assets with themselves (Statutory Liquidity Ratio or SLR). These ratios are crucial because they determine how much of the deposits banks can actually lend out.

If the reserve ratio is high, banks must hold a larger proportion of their deposits as reserves. This leaves a smaller amount available for lending. Consequently, the potential for credit creation in the economy decreases. Conversely, if the reserve ratio is low, banks have more funds available to lend, leading to a greater expansion of credit. Therefore, an increase in the reserve ratio leads to a decrease in credit creation, and a decrease in the reserve ratio leads to an increase in credit creation. This clearly demonstrates an inverse relationship between the reserve ratio and the credit creation process.

Important

The credit multiplier, which indicates how much credit can be created from an initial deposit, is inversely related to the reserve ratio. A higher reserve ratio means a lower credit multiplier and thus less credit creation.

Next, let's consider Statement 2: "Central Bank of an economy performs the vital function of controlling the credit creation process."

The Central Bank (like the Reserve Bank of India) is the apex monetary authority of a country. One of its primary and most critical functions is to regulate and control the money supply and credit in the economy. This control is essential for maintaining price stability, promoting economic growth, and ensuring financial stability. The Central Bank employs various tools, often referred to as instruments of monetary policy, to achieve this.

These tools include:

Quantitative Measures: These affect the overall supply of credit in the economy.
- Reserve Ratios (CRR and SLR): By changing these ratios, the Central Bank directly influences the amount of funds available with commercial banks for lending, thereby controlling credit creation. …

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