Limits to Credit Creation and Money Multiplier

The Central Bank's Limit on Credit Creation

The idea that a bank can keep lending out every rupee it receives might suggest that banks could create an unlimited amount of money. But there is a crucial check on this process, and it comes from the central bank — the Reserve Bank of India (RBI). The RBI imposes a legal requirement on every bank to hold a certain fraction of its total deposits as reserves. This is not a voluntary choice; it is a binding rule designed to prevent banks from lending too recklessly.

This required fraction is called the Cash Reserve Ratio (CRR). It is defined as the percentage of total deposits that a bank must keep as cash reserves with itself (or, in practice, with the RBI). For example, if the CRR is 20 per cent, then for every ₹100 of deposits, the bank must hold ₹20 as cash and cannot lend that amount.

The Money Multiplier Process: A Step-by-Step Example

To see exactly how the CRR limits credit creation, we return to our simplified economy with a single bank. Let us assume the bank starts with an initial deposit of ₹100 made by Leela. The CRR is 20 per cent.

Round 1:

• The bank receives ₹100 in deposits.
• It must keep 20% of ₹100 = ₹20 as required reserves.
• The remaining amount, ₹100 – ₹20 = ₹80, is available to lend.
• The bank lends ₹80 to Jaspal Kaur.

Round 2:

• Jaspal Kaur's loan of ₹80 is deposited back into the bank (as she spends it, the recipient deposits it). Total deposits now become ₹100 (original) + ₹80 (new) = ₹180.
• The bank must now keep 20% of ₹180 = ₹36 as required reserves.
• It started with ₹100 in cash. After keeping ₹36, it can lend ₹100 – ₹36 = ₹64.
• The bank lends ₹64 to Junaid.

Round 3:

• Junaid's loan of ₹64 is deposited back. Total deposits become ₹180 + ₹64 = ₹244.
• Required reserves become 20% of ₹244 = ₹48.80.
• The bank can lend ₹100 – ₹48.80 = ₹51.20.

This process continues. In each round, the bank lends out the excess reserves (the amount above the required reserve). That loan, when deposited, increases total deposits, which in turn raises the required reserves. The process repeats until the required reserves exactly equal the initial cash of ₹100.

When will that happen? Required reserves will be ₹100 only when total deposits reach ₹500, because 20% of ₹500 = ₹100. At that point, the bank can lend no more. The entire process is summarised in the table below.

The Final Balance Sheet and Money Supply

At the end of the process, the bank's balance sheet looks like this:

The bank holds ₹100 in reserves (20% of ₹500) and has given out ₹400 in loans. The total money supply in this economy, measured as M1 (currency + deposits), is now:

• Currency = ₹0 (no currency is held by the public; all money is in deposits)
• Deposits = ₹500
• M1 = ₹500

Thus, starting from an initial deposit of ₹100, the banking system has created an additional ₹400 in deposits, raising the total money supply to ₹500. The initial ₹100 of reserves has supported ₹500 of deposits.

The Money Multiplier

The ratio of total deposits created to the initial reserve is called the money multiplier. In our example:

This multiplier is the reciprocal of the reserve ratio. With a CRR of 20% (or 0.20), the multiplier is $1 / 0.20 = 5$. In general, if the reserve ratio is $r$ (expressed as a decimal), the money multiplier is $1/r$.