Credit (money) creation by commercial banks
Banks know that depositors do not all withdraw at the same time. So a bank keeps only a fraction of deposits as cash reserves and lends the rest. The RBI fixes the minimum fraction: the legal reserve ratio (LRR), made of CRR and SLR.
- Asha deposits ₹1000 (primary deposit). LRR = 20%, so reserves ₹200, loan ₹800.
- Ravi spends ₹800. The seller deposits it: a new (derived) deposit of 800. Reserves 160, loan 640.
- This repeats: 512, 409.6, … Each round is 80% of the last.
Total deposits = 1000 + 800 + 640 + … = 1000 × 1/0.2 = ₹5000. Credit created = 5000 − 1000 = ₹4000. The process ends when total reserves = the first ₹1000.
Money multiplier
Money multiplier = 1 ÷ LRR. LRR 20% → 5; LRR 10% → 10. Lower LRR = more credit.
Assumptions and limits
All money comes back to banks (no cash kept by the public), banks lend all excess reserves, and people want to borrow. In real life cash leakage and low loan demand make the multiplier smaller.
Central bank: functions of the RBI
The central bank is the top bank of a country. In India it is the Reserve Bank of India (1935).
- Currency authority: sole right to issue notes (except ₹1). Keeps public trust in money.
- Banker to the government: keeps government accounts, gives it short loans, manages public debt, advises on money matters.
- Bankers' bank and supervisor: banks keep reserves with it; it clears cheques between banks; it licenses and checks banks.
- Lender of last resort: gives loans to a bank in trouble so depositors don't panic.
- Controller of credit: uses monetary policy tools to control money supply, prices and growth.
- Custodian of foreign exchange reserves: keeps the country's foreign currency and gold and steadies the rupee's exchange rate.
Tools of credit control
Quantitative tools (change total credit)
- Repo rate: rate at which the RBI lends short-term to banks (against government securities). Higher repo → costlier loans → less credit.
- Reverse repo rate: rate the RBI pays banks for parking their extra money with it. Higher reverse repo → banks park more, lend less.
- Bank rate: rate at which the RBI lends to banks for longer periods without buying securities (rediscounting). Higher → less credit.
- Cash reserve ratio (CRR): part of deposits banks must keep as cash with the RBI. Higher CRR → less money to lend.
- Statutory liquidity ratio (SLR): part of deposits banks must keep themselves in liquid assets (cash, gold, government bonds). Higher SLR → less to lend.
- Open market operations (OMO): RBI buys or sells government bonds in the open market. Selling takes money out of banks → less credit. Buying puts money in → more credit.
Qualitative tool
- Margin requirement: the gap between the value of a thing pledged and the loan given against it. Margin 40% on ₹10 lakh of goods → loan only ₹6 lakh. Raising margins for, say, speculative stock trading cuts credit to that area only.
| To fight inflation (cut credit) | To fight slowdown (raise credit) |
|---|---|
| Raise repo, reverse repo, bank rate, CRR, SLR, margin; sell bonds | Lower them; buy bonds |
Key formulas and definitions
- Money multiplier = 1 ÷ LRR
- Total deposits = Initial deposit × 1/LRR
- Credit created = Total deposits − Initial deposit
- Loan against security = Value of security × (1 − margin)
Worked examples
1. Initial deposit ₹2000, LRR 10%. Find the money multiplier and total deposits.
Multiplier = 1 ÷ 0.1 = 10. Total deposits = 2000 × 10 = ₹20,000.
2. Initial deposit ₹5000, LRR 25%. Find credit created.
Total deposits = 5000 × 4 = 20,000. Credit created = 20,000 − 5000 = ₹15,000.
3. Total deposits created ₹40,000 from an initial deposit of ₹8,000. Find the LRR.
Multiplier = 40,000 ÷ 8,000 = 5. LRR = 1 ÷ 5 = 20%.
4. Show the first three rounds when ₹500 is deposited and LRR = 20%.
Round 1: deposit 500, reserve 100, loan 400. Round 2: deposit 400, reserve 80, loan 320. Round 3: deposit 320, reserve 64, loan 256.
5. A trader pledges goods worth ₹10 lakh. Margin requirement is 30%. How much loan can he get?
Loan = 10 × (1 − 0.3) = ₹7 lakh.
6. Inflation is high. Name any three steps the RBI can take.
Raise the repo rate, raise the CRR, sell government bonds in the open market (OMO). Any of: raise reverse repo, bank rate, SLR or margin also work.
Common mistakes
- Using multiplier = LRR instead of 1 ÷ LRR.
- Mixing up repo and reverse repo: repo = RBI lends to banks; reverse repo = banks lend (park money) with the RBI.
- Saying CRR is kept by banks with themselves. CRR is kept with the RBI; SLR is kept by the banks themselves.
- Thinking the RBI buying bonds reduces money supply. Buying pays money into the system, so money supply rises.