Credit Creation by Commercial Banks

Commercial banks do more than store money — collectively, they create credit, expanding the total volume of deposits (and hence money) to a multiple of the initial cash they receive. This happens because banks know from experience that only a fraction of deposits is withdrawn at any time, so they keep only a fraction as a cash reserve and lend out the rest.

The reserve ratio. The fraction of deposits a bank must keep as reserves is the reserve ratio (in India, the legally required part is the Cash Reserve Ratio, CRR, prescribed by the RBI). Suppose the reserve ratio is $r$ (expressed as a fraction).

The process. A bank receiving an initial (primary) deposit of $D$ keeps $rD$ as reserve and lends $(1-r)D$. The borrower spends it, and the money returns to the banking system as a fresh deposit, of which again a fraction $(1-r)$ is lent, and so on. Summing the geometric series of deposits gives:

and the credit (deposit) multiplier is $\dfrac{1}{r}$. The total credit (new loans) created is $D \times \dfrac{1-r}{r}$, i.e. total deposits minus the initial deposit.

Worked illustration (initial deposit ₹1,000, reserve ratio 20% i.e. $r = 0.2$):