Explain the process of money creation by a commercial bank using a hypothetical numerical example.

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Q. Explain the process of money creation by a commercial bank using a hypothetical numerical example.

Telangana TsbieCBSE Class XII Board 2019Subjective· 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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Commercial banks create money through a process called fractional reserve banking, where they lend out a portion of their deposits, leading to a multiple expansion of the initial deposit across the banking system.

Commercial banks play a crucial role in an economy beyond just facilitating transactions; they are significant creators of money. This process, often referred to as credit creation or deposit creation, is based on the principle of fractional reserve banking.

The core idea is that banks do not need to hold 100% of their deposits as reserves. Instead, they are legally required to keep only a fraction of their total deposits as reserves (known as the Legal Reserve Ratio, LRR, which includes the Cash Reserve Ratio, CRR, and Statutory Liquidity Ratio, SLR). The remaining portion can be lent out. When a bank lends money, it doesn't typically hand over physical cash; instead, it credits the borrower's account. This credit becomes a new deposit in the banking system, either in the same bank or another bank, which then allows that bank to lend out a fraction of this new deposit, and so on. This continuous cycle of deposits leading to loans, and loans leading to new deposits, multiplies the initial deposit, thereby increasing the total money supply in the economy.

Let's illustrate this process with a hypothetical numerical example:

Assume the Legal Reserve Ratio (LRR) is 20% ( $0.2$ ).

Suppose there is an initial fresh deposit of ₹10,000 in Bank A.

Initial Deposit:
- A customer deposits ₹10,000 into Bank A. This is the primary deposit.
- Bank A now has ₹10,000 in deposits.
First Round of Lending:
- According to the LRR of 20%, Bank A must keep $20\%$ of ₹10,000 as reserves.
- Reserves kept by Bank A: $0.2 \times ₹10,000 = ₹2,000$ .
- The remaining amount can be lent out: $₹10,000 - ₹2,000 = ₹8,000$ .
- Bank A lends ₹8,000 to a borrower. This loan amount is typically credited to the borrower's account, or the borrower draws a cheque which is then deposited into another bank (or even the same bank).
Second Round of Lending:
- Assume the borrower from Bank A deposits the ₹8,000 into Bank B.
- Bank B now has a new deposit of ₹8,000.
- Bank B must keep $20\%$ of ₹8,000 as reserves.
- Reserves kept by Bank B: $0.2 \times ₹8,000 = ₹1,600$ .
- The remaining amount can be lent out: $₹8,000 - ₹1,600 = ₹6,400$ .
- Bank B lends ₹6,400 to another borrower.
Third Round of Lending:
- Assume this new borrower deposits the ₹6,400 into Bank C.
- Bank C now has a new deposit of ₹6,400.
- Bank C must keep $20\%$ of ₹6,400 as reserves.
- Reserves kept by Bank C: $0.2 \times ₹6,400 = ₹1,280$ .
- The remaining amount can be lent out: $₹6,400 - ₹1,280 = ₹5,120$ .
- Bank C lends ₹5,120 to yet another borrower.

This process continues, with each subsequent loan becoming a new deposit in another bank, which then keeps a fraction as reserves and lends out the rest. The amount available for lending decreases in each round because a portion is held as reserves. …

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Q.Explain the process of money creation by a commercial bank using a hypothetical numerical example.

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