Page 62 - DCOM208_BANKING_THEORY_AND_PRACTICE

Unit 4: Credit Creation

Notes
The amount advanced to D will return ultimately to the banking system, as described in
case of B and the process of deposits and credit creation will continue until the reserve
with the banks is reduced to zero. The final picture that would emerge at the end of the
process of deposit & credit creation by the banking system is presented in the consolidated
balance sheet of all banks are as under:
Bank Liabilities Assets Credits Reserve Total Assets
Deposits
Bank 1 100 95 5 100
Bank 2 95 90.5 4.75 95
Bank 3 90.5 85.98 4.52 90.5
- - - - -
- - - - -
Bank n 00 00 00 00
Total 2,000 1,900 100 2,000

It can be seen from the combined balance sheet that a primary deposits of ` 100 in a bank
1 leads to the creation of the total deposit of ` 2,000. The combined balance sheet also
shows that the banks have created a total credit of ` 2,000. And maintained a total cash
reserve of ` 100 which equals the primary deposits. The total deposit created by the
commercial banks constitutes the money supply by the banks.
Source: http://www.indianmba.com/Occasional_Papers/OP217/op217.html

4.1.2 Contraction of Credit

The money supply is adversely affected by the contraction of credit. The contraction of bank
credit may take place due to many reasons.

Example: The bank may recall loans or due to political uncertainty or due to fall in price
borrower may stop the borrowing.
According to Pritchard, “Contraction by any single bank in this system will place pressure on other
banks and if their excess reserve position is inadequate and the banks are unable to meet their excess
reserves through the agency of the central bank then a multiple process of credit contraction will start.”

Self Assessment

Fill in the blanks:

1. Credit creation constitutes the major component of money supply in the ………………….
2. When the customer deposits money with the bank, they are called …………………….
deposits.

3. ………………………… bank is the first source of money supply in the form of currency in
circulation.
4. The RBI ensures availability of currency to meet the …………………………… needs of the
economy.
5. The …………………………… banks are the second most important sources of money
supply.

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