Page 156 - DECO402_Macro Economics

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

Where does the loan amount of ` 900 go? If the person taking the loan give the cheque of ` 900 to Notes
some other person (who has an account in the same bank), then there is no disturbance in bank’s
cash reserve of ` 1000. Bank’s demand deposit becomes 1900 for which it needs cash reserve

fund of ` 190   10 × 1,900 . In such situation, bank is left with an excess reserve of ` 1000 – 190 =

 100 
` 810. For bank it will be possible to give another loan of ` 810. Accordingly, bank’s demand deposit
will increase to Rs.1000 + 900 + 810 = 2710. If the person taking the loan gives the cheque of ` 810
to another person (who has an account with the same bank), there will be again no disturbance in
bank’s cash reserve of ` 1000. Bank, by keeping ` 271 (10% of 2710) in cash reserve fund, for demand
deposit of ` 2710, will be able to give its excess reserve of ` 729 (1,000 – 271) in form loan to some
other person. This process of giving loan by the bank will go on until excess reserve becomes zero.
At the end bank’s balance sheet will be as follows:

Balance Sheet of the Bank
(When excess reserve ends completely)

Liabilities Assets
Demand Deposits (i) Cash received = ` 1,000
(i) Primary Deposit = ` 1,000 (ii) Loan = ` 900

(ii) Secondary and derivatives deposit = ` 900 = ` 810
` 810 = ` 729
` 729
This cycle will go on until excess fund does not become zero
Total = ` 1,0000 Total = ` 1,0000

In this manner, on the basis of cash received of ` 1,000, bank created demand deposits of ` 1,0000.
 1 1 

 × 1,000 = × 1000 = Rs.10,000 because in this example, credit multiplier is 10.
 CRR 10% 
1 1
Credit multiplier = = = 10
CRR 10%
There is an increase of ` 10000 in supply of money/ credit in the economy.
Conclusion: On an initial increase of ` 1,000 in bank’s demand deposit (in form of primary deposit) and
on the basis of assumption of CRR to be 10%, bank’s demand deposit (sum of primary and secondary
deposits) will increase to ` 1,0000.

Algebraic Expression

Algebraic expression of credit creation process as following:
ΔD = ΔP + ΔP (1 – r) + ΔP (1 – r) + ΔP (1 – r) +...........
2
3
= ΔP {1 + (1 – r) + (1 – r) + (1 + r) +.........}
2
3
Where, ΔD: Net change in demand deposit because of initial change of primary deposit.
ΔP: change in Primary deposit
r: Cash Reserve Ratio (CRR)

LOVELY PROFESSIONAL UNIVERSITY 149