Page 155 - DECO402_Macro Economics

Macroeconomic Theory

Notes 4. Loans do of deposits—
(a) Selection (b) Creation
(c) Credit (d) None of these
5. Ratio of increase in primary deposits and increase in total deposits is called—
(a) Credit multiplier (b) Credit
(c) Multiplier (d) None of these
6. Excess reserve itself becomes of the credit creation—
(a) Base (b) Budget
(c) Multiplier (d) None of these
17.4 Process of Credit Creation or How do Banks Create Credit?

Commercial banks’ method of credit expansion is based on the following conditions:
(i) Stability in Cash Reserve ratio of banks: Cash reserve ratio of net commercial deposits of
banks, remain constant during the period of credit creation process.
(ii) No flow of cash: Excessive flow of cash should not happen from the banking system i.e.
people should keep a designated amount of currency with them for exchange.
Study of process of credit creation can be done in two parts:
(1) Single Banking System (2) Multiple Banking System
(1) Credit Creation in a single banking system

It is just an easy assumption that in an economy only one bank does all the banking business. Assume
that MR. X deposits `. 1000 in the bank. In form of primary deposit, this amount is demand deposit
of the bank. On this assumption that CRR is 10%, Bank’s balance Sheet will look like this:

Balance Sheet of the Bank
(On primary deposit being ` 1000)

Liabilities Assets
Demand Deposits… .` 1000 Cash = ` 1000
(Primary Deposit) Cash Reserve fund = ` 100 (10% of 1000)
Excess Reserve = 1000 – 100 = ` 900
Total = ` 1000 Total = ` 1000

Without liquidity or security risk, bank can give a loan of ` 900. If bank does so, its explanation will
be as follows:

Balance Sheet of the Bank
(When initial excess reserve is converted to
loan)

Liabilities Assets
(i) Demand Deposits (Primary Deposit) `. 1000 (i) Cash received = ` 1,000
(ii) Demand Deposits = ` 900 Cash Reserve fund (10% of 1000) = ` 100
(Secondary and derivatives deposits) Excess Reserve = 1000-100 = `900
(ii) Loan = ` 900
Total = ` 1,900 Total = ` 1,900

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