Page 162 - DECO402_Macro Economics

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

In competitive banking system quantity of credit Notes
of banks is determined by demand for loans and
supply of loans. Demand for loan depends on
the prevailing interest rates and supply of loan
depends on quantity of deposit and spread of
interest rates What interest rate banks give for
accepting deposits from people and what interest
rate banks charge for giving loans to the people,
the difference between it is known as spread of
interest rates. Spread of interest rate is decided
by loan supply line and deposit supply line.
Demand for loan is inversely related with interest
rates. Excessive interest rate reduces demand Figure 17.2
for loan and less interest rate increases demand
for loan. In this manner loan demand curve is a downward falling line. Supply of loan and supply
of deposit is directly related to rate of interest. On high interest rates banks do a greater supply of
money and people deposit more cash in banks. Slope of both loan supply and deposit supply line is
upwards.
In figure 17.2, S is line for supply of loan; S is line for supply of deposit. D is the demand curve
L
d
L
of loan. Balanced Rate of interest is Or where D = S . It is that rate of interest which bank receives
L
L
for giving loan to the people. Or is that rate of interest which bank gives to the people on deposit
1
amount. Difference between both interest rates rr (spread of interest rate) determines the quantity
1
of loan supply by the banks.
In the figure, interest rate spread is assumed to be constant that is why loan supply curve and deposit
supply curve are mutually parallel. Quantity of loan supply by the banks depends on interest rate
spread and deposit supply. Undoubtedly, when there is a boom in money market then for adjusting
supply of loan and demand of loan, excess reserves of the bank have a very important role.
17.7 Do Banks Really Create Credit?

There is a difference of opinion found among the economist that in reality whether credit is created by
banks or depositors. Walter Leaf and Cannon’s opinion is that banks do not themselves create credit.
Depositors do the job of credit creation who through their deposits, provide monetary resource to the
banks. One part of this deposit is given by the banks as loan. This loan is helpful in credit creation.
If depositor does not deposit his money in bank, bank will not be able to create credit. Bank may be
compared to a cloak room. Assume that, in a party 50 guests come with simmilar overcoats which
they deposit in a cloak room. Also assume that party will continue till 12 O’ Clock. Watchman of the
cloak room keeps 10 overcoats with himself and gives the rest 40 overcoats to other people on rent
for until 11:30 at night. He has kept 10 overcoats with himself because if some people want to go from
the party before 12 O’Clock then he may give them these coats. Thus in this manner, by giving 40
overcoats for rent, has the watchman created 40 new overcoats? It is absolutely wrong. In the same
way bank also by lending the money of the depositors, does not create credit. Keeping this in mind,
Cannon has said, "The talk of credit creation by banks is all moon-shine and that every practical
banker knows that he is not a creator of credit or money or anything else but a person who facilitates
the lending of resources by the people who have them, to those who can use them."
But according to modern economists, above thought of Walter Leaf and Cannon is not correct, because
banks lend money more than primary deposit. That is why, it will have to be accepted that banks
create credit. Hartley Withers have rightly said, "Loans make deposits and the initiative of creating
them goes to the banks."

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