Illustrate the process of credit creation by commercial banks with the help of a numerical example. OR Explain

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Q. Illustrate the process of credit creation by commercial banks with the help of a numerical example.

(OR)

Explain the following functions of the Central bank :

(a) Bankers’ bank

(b) Currency issuing authority

Manipur CohsemCOHSEM Manipur Higher Secondary Board (Commerce) 2025Subjective· 8mImportance★★★★★

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Concept understanding — Central Bank Credit Control Instruments (Bank Rate, Repo, CRR/SLR)

How One Bank Controls the Money of a Whole Nation

The Reserve Bank of India cannot walk into every shop and set prices, yet it powerfully influences how much money circulates in the economy. It does this by controlling credit — the loans that commercial banks create. When banks lend freely, money supply expands; when lending tightens, it contracts. The RBI's toolkit for tuning this is called its instruments of monetary policy.

Credit Control = the regulation of the volume, cost and direction of credit created by commercial banks, undertaken by the central bank to manage money supply and price stability.

The tools fall into two families: quantitative (affecting the total volume of credit) and qualitative (affecting its direction).

Quantitative Instruments

1. Bank Rate

The bank rate is the rate at which the central bank lends to commercial banks for their long-term needs. Raise it → borrowing from the RBI becomes costlier → banks raise their own lending rates → loans fall → money supply contracts. Lower it to expand credit.

2. Repo Rate and Reverse Repo Rate

Repo rate — the rate at which the RBI lends to banks for their short-term needs against government securities. A hike (e.g. a rise in the benchmark lending rate by 140 basis points) makes credit dearer, curbs borrowing, and helps fight inflation.
Reverse repo rate — the rate at which the RBI borrows from banks, absorbing surplus liquidity.

3. Reserve Ratios (CRR and SLR)

Banks must keep a fraction of their deposits in reserve, so they cannot lend everything:

CRR (Cash Reserve Ratio) — the fraction of deposits banks keep as cash with the RBI.
SLR (Statutory Liquidity Ratio) — the fraction they keep with themselves in liquid assets (cash, gold, government securities).

Raising CRR or SLR leaves banks less to lend, contracting credit; lowering them expands it. Their power is magnified by the money multiplier:

\text{Money Multiplier} = \frac{1}{\text{CRR}}

4. Open Market Operations (OMO) …

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Commercial banks create credit through the deposit-lending cycle -- each bank keeps only a fraction of a deposit as a reserve (the Legal Reserve Ratio) and lends out the rest, which re-enters the banking system as a fresh deposit elsewhere, repeating round after round until total deposits/credit created equal the initial deposit multiplied by 1/LRR (the credit multiplier); separately, two key functions of the central bank are acting as banker to commercial banks and holding the sole authority to issue currency.

Credit creation -- numerical illustration:

Assume an initial primary deposit of Rs. 1,000 is made in Bank A, and the Legal Reserve Ratio (LRR) fixed by the central bank is 20% (0.20).

Round	Bank	New Deposit (Rs.)	Reserve kept (20%)	Amount lent out (80%)
1	Bank A	1,000	200	800
2	Bank B	800	160	640
3	Bank C	640	128	512
...	...	...	...	...

Each bank keeps 20% of the deposit it receives as reserve (as mandated) and lends out the remaining 80%, which becomes a fresh deposit in another bank, and the process continues. Summing this infinite geometric series of deposits:

Total Credit (Deposit) Creation = Initial Deposit x (1 / LRR) = 1,000 x (1 / 0.20) = 1,000 x 5 = Rs. 5,000

Thus, an initial deposit of Rs. 1,000 ultimately leads to total deposits (credit) of Rs. 5,000 being created in the banking system -- total new credit created (excluding the original deposit) being Rs. 4,000. This illustrates the credit-multiplier process of commercial banks.

OR -- Functions of the Central Bank: …

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

CBSE 2023Set 58/1/11 markMCQ
$Q. The rate at which commercial banks borrow from the Reserve Bank of India to meet their long term requirements is known as ____________. (Choose the correct alternative to fill up the blank) (A) Margin requirement (B) Bank rate (C) Repo rate (D) Reverse repo rate$
›Reveal solutionSolution
The question asks for the rate at which commercial banks borrow from the RBI for long-term needs. The correct answer is the Bank rate, because it is the rate for long-term borrowing (without repurchase agreements), unlike the Repo rate which is for short-term borrowing.

The key here is to understand the purpose and duration of borrowing. The Reserve Bank of India (RBI) acts as the Lender of Last Resort for commercial banks. When banks face a shortage of funds, they can borrow from the RBI. But the rate charged depends on how long they need the money and what collateral they offer.

Let’s break down the options:

Repo rate: This is the rate at which banks borrow from the RBI for short-term needs (usually overnight to 14 days) by selling government securities with an agreement to repurchase them. It’s a secured, short-term loan.

Reverse repo rate: This is the opposite — the rate at which the RBI borrows from commercial banks. So it’s not a rate at which banks borrow.

Margin requirement: This refers to the difference between the market value of a security and the loan amount given against it (a kind of collateral buffer). It’s not a rate of interest at all.

Bank rate: This is the rate at which the RBI lends to commercial banks for long-term requirements (typically for periods longer than 14 days, and without any repurchase agreement). It is also called the discount rate because the RBI used to rediscount bills of exchange at this rate. …
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CBSE 2023Set ANNUAL1 markMCQ
$Q. Selective Control Method aim at — (A) Changing the volume of a specific type of credit. (B) Changing the bank rate. (C) Open market operation. (D) Changing the Cash Reserve Ratio.$
›Reveal solutionSolution
Selective (qualitative) credit control methods used by the central bank are aimed at controlling the flow of credit to a specific sector or purpose, not the overall/general supply of credit in the economy.

Central banks use two broad categories of credit control instruments:

Quantitative (general) methods — affect the total volume of credit in the economy as a whole, without discriminating between its uses. These include the Bank Rate, Open Market Operations, and the Cash Reserve Ratio/Statutory Liquidity Ratio.

Qualitative (selective) methods — aimed at controlling credit for specific purposes or sectors (e.g., curbing speculative lending against shares, or controlling credit for a particular commodity), without affecting the overall volume of credit available to other sectors. Tools here include changing margin requirements, rationing of credit, and moral suasion directed at specific types of lending.

…
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CBSE 2023Set ANNUAL1 mark
$Q. Analyse how raising of bank rate affect availability of credit.$
›Reveal solutionSolution
The bank rate is the rate at which the central bank lends to commercial banks / rediscounts their eligible bills; raising it makes borrowing from the central bank more expensive, which commercial banks pass on to their own borrowers, contracting credit.

Chain of effect:

Central bank raises the bank rate.

Commercial banks' own cost of borrowing from the central bank (and of rediscounting bills) rises.

Banks respond by raising the interest rates they charge their own customers on loans and advances.

Borrowing becomes more expensive for businesses and households, so the demand for bank credit falls. …
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Q.Illustrate the process of credit creation by commercial banks with the help of a numerical example.

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