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Questions
Explain briefly the process of credit creation by commercial banks.
Explain the money creation process by the commercial banks with the help of an example.
Solution
- Credit creation (or money creation) is the expansion of derivative deposits. It is a process where a bank uses a part of its customer's deposits to offer loans to other individuals and businesses.
- This results in more money created in an economy. Banks can expand their demand deposits as a multiple of their cash reserves became demand deposits serve as the principal medium of exchange.
Example: Example: Suppose the amount of initial deposit is ₹ 1000 and LRR is 10%. The banks will keep 10%, i.e. ₹ 100 as reserve and lend the remaining ₹ 900 to borrowers. The borrowers will spend this money. It is assumed that ₹ 900 comes back to the bank. Bank again keep 10% of ₹ 900, i.e., ₹ 90 reserve and lend ₹ 810. This will further raise the amount of deposits with the banks. In this way, deposits go on increasing. The number of times, the total deposits will become, is determined by the money multiplier:
Money Multiplier = `1/"LRR" = 1/0.10 = 10`
The total deposits will be:
Initial deposits × Money Multiplier
= ₹ 1000 × 10
= ₹ 10,000
RELATED QUESTIONS
Credit creation by the commercial bank is determined by ______.
Access to adequate and timely credit at affordable rates is critical for the rural poor to alleviate high cost debt and invest in livelihood opportunities. Despite the Government of India's best efforts, financial inclusion of the rural poor has been beset with multiple challenges. Lack of adequate banking infrastructure and human resources in rural areas, unplanned expansion leading to unviable bank branches and low levels of financial literacy amongst the rural populace have been some of the key challenges.
The most vulnerable communities, who often had no formal credit history or ability to provide collateral, have often been the worst affected. Inability to access loans from banks meant that the poorest had to resort to moneylenders for loans at unreasonably high rates of interest that invariably led them into a toxic debt trap.
In this context, the SHG-Bank Linkage programme, formalised by the National Bank for Agriculture and Rural Development (NABARD) in 1995, synthesizes 'formal financial systems' (in terms of a formal institution providing credit) with the 'informal sector' (comprising of rural poor with no formal credit history), has emerged as a preferred vehicle for providing financial services to the hitherto unbanked poor.
Community Based Repayment Mechanisms (CBRMs) have been institutionalised at branches involved in financing SHGs to monitor and ensure timely repayment of loans by SHGs. The number of SHGs with outstanding bank loans stands at nearly 5 million today, implying that the program has brought formal banking services to over 50 million women.
Why is it important to ensure access to cheap formal sector credit to the rural poor?
Access to adequate and timely credit at affordable rates is critical for the rural poor to alleviate high cost debt and invest in livelihood opportunities. Despite the Government of India's best efforts, financial inclusion of the rural poor has been beset with multiple challenges. Lack of adequate banking infrastructure and human resources in rural areas, unplanned expansion leading to unviable bank branches and low levels of financial literacy amongst the rural populace have been some of the key challenges.
The most vulnerable communities, who often had no formal credit history or ability to provide collateral, have often been the worst affected. Inability to access loans from banks meant that the poorest had to resort to moneylenders for loans at unreasonably high rates of interest that invariably led them into a toxic debt trap.
In this context, the SHG-Bank Linkage programme, formalised by the National Bank for Agriculture and Rural Development (NABARD) in 1995, synthesizes 'formal financial systems' (in terms of a formal institution providing credit) with the 'informal sector' (comprising of rural poor with no formal credit history), has emerged as a preferred vehicle for providing financial services to the hitherto unbanked poor.
Community Based Repayment Mechanisms (CBRMs) have been institutionalised at branches involved in financing SHGs to monitor and ensure timely repayment of loans by SHGs. The number of SHGs with outstanding bank loans stands at nearly 5 million today, implying that the program has brought formal banking services to over 50 million women.
There are two statements given below, marked as Assertion (A) and Reason (R). Read the statements and choose the correct option.
Assertion (A): Micro-credit can help empower women and make them financially independent.
Reason (R): Micro-credit involves small loans provided at reasonable interest rates that can help people start their own ventures.
Explain the role of legal reserve ratio and Bank rate in correcting inflationary gap in an economy.
Match the following:
| Column I | Column II | ||
| A. | Primary deposits | (i) | Payable on demand |
| B. | Derivative deposits | (ii) | Deposits for a fixed period of time |
| C. | Demand deposits | (iii) | Cash deposits of people |
| D. | Term deposits | (iv) | Deposits created by banks (or loan deposits) |
Read the following statements - Assertion (A) and Reason (R). Choose one of the correct alternatives given below:
Assertion (A): Credit Creation comes to an end when total cash reserves become equal to the initial deposits.
Reason (R): The value of money multiplier is determined by Legal Reserve Ratio (LRR).
Match the following:
| Column I | Column II | ||
| A. | Formula of Money Multiplier | (i) | Inverse |
| B. | Money multiplier = 4 | (ii) | Money multiplier = 10 |
| C. | Relationship between LRR and money multiplier | (iii) | LRR = 0.25 |
| D. | LRR = 0.1 | (iv) | `1/"LRR"` |
State the advantage of a credit card over currency notes.
What are secondary (derivative) deposits?
Why are the banks required to keep only a fraction of deposits as cash reserves?
