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Questions
Currency is issued by the central bank, yet we say that commercial banks create money. Explain. How is this money creation by commercial banks likely to affect the national income? Explain
Why do we say that commercial banks create money while we also say that the central bank has the sole right to issue currency? Explain. What is the likely impact of money creation by the commercial banks on national income?
Solution
Commercial banks create money even though they cannot print money. Bank deposits form the basis for credit creation. They accept deposits from the public by opening deposit account known as the primary deposit. Banks do not hold the money in the account itself, and the entire amount is not withdrawn from the account at the same time. So, they advance loans to business persons and retain only a small portion of the total deposits in the bank. The Central Bank decides the amount to be held in the form of cash and the remaining amount is advanced as loans to business persons only against collateral securities. The bank will not give cash but open a derivative account in the name of the individual or institution. Here, the loans create a derivative deposit which is called a secondary deposit or derivative deposit. This secondary deposit is called the creation of credit. Hence, the banks are able to provide financial assistance to traders and industrialists. Their cheques and drafts are useful for trading on a large scale. It also provides concessional loans to the priority sectors such as agriculture, small-scale industry, retail trade and export. Thus, the production activity increases the overall development of the nation.
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