Credit creation by Commercial banks

Credit creation (or deposit creation or money creation) by the banks is determined by

(i) the amount of the initial fresh deposits and

(ii) the Legal Reserve Ratio (LRR)

Example :- Let the LRR be 20% and there is a fresh deposit of Rs.10,000. As required the banks keep 20% i.e. Rs.2,000 as cash. Suppose the banks lend the remaining Rs. 8,000. Those who borrow, use this money for making payments. As assumed those who receive payments put the money back into the banks. In this way bank receives fresh deposits of Rs. 8,000. The bank again keep 20% i.e. Rs.1,600 as cash and lend Rs.6,400, which is also 80% of the last deposits. The money again comes back to the banks leading to a fresh deposit of Rs.6,400. The money goes on multiplying in this way this process continues till new deposit become nil., and ultimately total money creation is Rs.50,000.

Total money creation = initial deposit x 1/LRR =10000 x1/20%

= 10000 x100/20

Total money creation = 50000.

Where Money multiplier is 1/LRR=1/20%=1/20*100=10/2= 5

It is the multiple by which total deposits increase due to initial deposit.