Credit Creation by Commercial Banks

Credit creation is the process by which the commercial banking system, taken as a whole, expands the total volume of money supply to a multiple of the original cash deposited with it. This is possible because banks operate on a fractional reserve system: the RBI requires every bank to keep only a fraction of each deposit as a reserve — the Cash Reserve Ratio (CRR) — and permits it to lend out the remainder.

Here is how the multiple expansion actually unfolds. Suppose a bank receives a fresh deposit of ₹1,00,000 and the CRR is 20%. The bank keeps ₹20,000 as reserve and lends out ₹80,000. The borrower spends this money, and it is very often redeposited into the banking system (directly, or after passing through a seller's account) — the receiving bank again keeps only 20% of this new ₹80,000 as reserve and lends out the rest, and the cycle repeats, with each successive round smaller than the last. The additional deposits created round after round form a diminishing geometric series that converges to a definite total.

The total credit (aggregate deposits) that the banking system as a whole can create from an initial fresh deposit is given by the credit multiplier formula:

$\text{Total Credit Creation} = \text{Initial Deposit} \times \frac{1}{\text{CRR}}$ …