(a) Elaborate the process of Credit Creation using a suitable numerical example. (b) Read the following text c

Question 51 of 67

Q. (a) Elaborate the process of Credit Creation using a suitable numerical example.

(b) Read the following text carefully : “This function of money provides different items to be evaluated against a common standard. It allows comparison of prices and keeping financial records.”

(i) On the basis of the given text, identify the indicated function of money.

(ii) List any other two functions of money.

Telangana TsbieCBSE Class XII Board 2025Subjective· 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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Credit creation is the process by which commercial banks multiply the initial deposit into a larger total money supply through repeated lending, using the reserve requirement as a the limiting factor. The text describes money’s unit of account function; the other two primary functions are medium of exchange and store of value.

(a) Credit Creation — The Process with a Numerical Example

Credit creation is one of the most powerful functions of a commercial bank. It is not about creating new currency notes — that is the central bank’s job. Instead, it is about creating demand deposits (bank money) through the process of lending.

Here is the core idea: When a bank gives a loan, it does not hand over cash from its vault. It simply opens a new deposit account in the borrower’s name, or credits the borrower’s existing account. That new deposit is new money — it can be spent, transferred, and re-deposited in another bank, starting the cycle again.

The only constraint is the Cash Reserve Ratio (CRR) — the fraction of deposits that banks must keep as reserves with the central bank. The rest can be lent out. This is why the process is often called multiple deposit expansion.

\text{Total Credit Created} = \text{Initial Deposit} \times \frac{1}{\text{CRR}}

Numerical Example

Suppose the central bank sets the CRR at 10% (i.e., 0.10). A customer deposits ₹1,000 in Bank A.

Step 1: Bank A keeps 10% of ₹1,000 = ₹100 as reserve. It lends out the remaining ₹900 to a borrower (say, a shopkeeper).
Step 2: The shopkeeper spends the ₹900 buying goods. The seller deposits that ₹900 in Bank B.
Step 3: Bank B keeps 10% of ₹900 = ₹90 as reserve. It lends out ₹810 to another borrower.
Step 4: That ₹810 gets deposited in Bank C. Bank C keeps ₹81 as reserve and lends ₹729.
… and so on.

The total deposits (and hence total credit) created from the initial ₹1,000 is:

\text{Total Deposits} = 1000 + 900 + 810 + 729 + \dots

This is an infinite geometric series with first term $a = 1000$ and common ratio $r = 0.9$ (since 90% of each deposit is re-lent). The sum is:

S = \frac{a}{1 - r} = \frac{1000}{1 - 0.9} = \frac{1000}{0.1} = ₹10,000

So, an initial deposit of ₹1,000 has created total deposits (and credit) of ₹10,000. The money multiplier here is 10.

Watch out

A common mistake is to think that the bank creates credit out of thin air without any backing. In reality, every loan is backed by the reserves held by the bank. The process works only because the banking system as a whole recycles deposits. Also, the multiplier works fully only if all loaned money is re-deposited in the banking system — if people hold cash, the multiplier shrinks.

(b) Functions of Money

(i) Identify the function from the text

The text says: “This function of money provides different items to be evaluated against a common standard. It allows comparison of prices and keeping financial records.” …

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Q.(a) Elaborate the process of Credit Creation using a suitable numerical example.

(a) Credit Creation — The Process with a Numerical Example

(b) Functions of Money

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