Page 154 - DECO402_Macro Economics

Unit-17: Money Multiplier and Credit Creation by Commercial Banks

(i) Primary or Cash Deposits: The amount of money which is deposited by the people in Notes
form of cash in the banks is known as Primary or Cash Deposit. It is also known as passive
deposits because banks have no role in developing these deposits. Amount of these deposits
completely depends on the will of the depositor.
(ii) Derivatives or Secondary Deposits: When a person takes a loan from the bank, bank does
not give him this loan in form of cash but opens an account in his name and gives him a
right to withdraw money from it through cheque. Such deposit is known as Derivative or
Secondary deposit. Hence each loan given by bank creates a new deposit. Secondary deposit
is the result of primary deposit because banks create secondary deposit by keeping a part of
primary deposit itself in reserve. According to Halm, "Creation of secondary deposit is credit
creation; larger the amount that a bank advances greater is the creation of secondary deposits
or loans created." That is why it is said, “loans create deposits and deposits create loans.”
Demand Deposits = Primary Deposits + or Secondary Derivative Deposits
2. Cash Reserve Ratio: No doubt that banks want to earn more and more profits by giving loan
but it does not mean that it may lend its entire cash. The people who deposit their money in
bank may withdraw it anytime because it is their money. hence banks alsways keep a part
of net deposits in form of cash reserve with them, so that the requirement of the depositors
may be fulfilled. That part of net deposit which banks keep with themselves as cash is known
as Cash Reserve Ratio.
3. Excess Reserves: The amount with the bank which is more than the required cash reserve
ratio (CRR) is known as Excess Reserve. In reality, it is this excess reserve which becomes
the base of credit creation.
4. Credit Multiplier: Ratio of increase in primary deposit and increase in total deposit is known
as credit multiplier. If as a result of an increase of Rs. 1000 in primary deposits, there is a credit
creation of Rs. 10,000, credit multiplier will be 10. Inverse relation between credit multiplier
and Cash Reserve Ratio(CRR) may be expressed in form of following equation:
1
Credit Multiplier =
Cash Reserve Ratio
Difference between money multiplier and Credit Multiplier
Money multiplier: It is the ratio of supply of money and high powered money.

1c
+
m =
++
c r e
Credit Multiplier: It is the ratio of increase in total deposits and increase in primary deposits of the
banks or is the reciprocal of Cash Reserve Ratio (CRR).
∆ D = 1
Credit multiplier ∆ P r
Here, r= Reserve ratio, D = Total Deposits, P = Primary deposits.

Self Assessment
Multiple Choice Questions:
3. Creation of secondary deposit itself is —
(a) Credit creation (b) Credit
(c) Deposit (d)None of these

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