Credit Creation
1 Quick Explanation 1–3 min
When banks lend, they don't hand out their own cash — they create new deposits. This process multiplies money.
It's called credit creation, driven by fractional reserve banking.
2 Detailed Notes
Definition
What is credit creation?
Credit creation is the process by which commercial banks create demand deposits (money) out of a small initial deposit by lending the excess reserves, which return to the banking system as new deposits.
Key points
How it works (assume CRR = 10%)
- Deposit ₹1,000 (primary deposit). Bank keeps ₹100 as reserves, lends ₹900.
- Borrower deposits ₹900 into his bank. Bank keeps ₹90, lends ₹810.
- The ₹810 again becomes a deposit; bank keeps ₹81, lends ₹729… and so on.
- Total deposits created = 1000 × (1/0.10) = ₹10,000.
Formula
Formulas
Money multiplier = 1 ÷ LRR
Total deposits = Primary deposits × (1 ÷ LRR)
Total credit = Total deposits − (total deposits × LRR)LRR = Legal Reserve Ratio (CRR + SLR). The process stops when every rupee is held as reserve.
Key idea
Assumptions
- All banks keep exactly the LRR and lend the rest.
- Borrowers do not withdraw cash fully; they redeposit in the banking system.
- There is enough demand for loans.
- No cash leakages out of the system.
Key points
Limitations
- Cash drain (people hold cash outside banks).
- Lack of demand for credit in recession.
- Sticky deposit creation if banks hold excess reserves.
In One Minute
Credit creation: banks lend excess reserves → loans become new deposits → repeat. Deposits = Initial deposit × (1/LRR). Multiplier = 1/LRR.
Important for Exam
- ⭐ The ₹1,000 deposit, 10% LRR table → total deposits ₹10,000 (6 marks).
- ⭐ Money multiplier = 1/LRR.
- ⭐ Role of LRR in limiting credit.
- ⭐ Limitations of credit creation (3 marks).
Watch & Learn
Watch on YouTubeCredit creation by commercial bank - Banking Part 1. Class 12 Macro economics - DEPOSIT MULTIPLIER
by Sunil Panda-The Educator
Why watch? The standard board table process, step by step.
Open on YouTube Watch on YouTubeCredit creation by commercial bank - Banking Part 1. Class 12 Macro economics - DEPOSIT MULTIPLIER
by Sunil Panda-The Educator
Why watch? Full numerical: LRR, total deposits, total credit.
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