- Money is anything usable for undertaking transactions i.e. receipts and payments.
- The stock of such money in an economy is called money supply.
- The basic measure of money supply has two components: currency with public and demand deposits in commercial banks.
- The currency is created by the central bank (Reserve Bank of India in India) and is called High Powered Money.
- Demand deposits are created by the commercial banks and are called Bank money.
Commercial banks receive deposits from the public. The depositors are free to withdraw, in part or in full, their deposit amounts by writing cheques. The banks use the money in these deposits to give loans. These functions of the commercial banking system are the basis of deposit creation.
How much are the deposits created is determined by the amount of initial deposits by the public and the Legal Reserve Ratio. The quantitative outcome is called money multiplier.
INITIAL DEPOSIT – It refers to the deposit, which is made for the first time or it is fresh deposit.(It is not included amount deposited by taking loan)
Legal Reserve Ratio (LRR) – It is the minimum ratio of deposit legally required to be kept as cash by the banks. LRR includes:
(i) Cash Reserve Ratio – It is the minimum proportion of cash reserves which is kept by commercial banks with the central bank against its total deposits; and
(ii) Statutory Liquidity Ratio – It is that proportion of the total deposits which a commercial bank has to keep with itself in the form of liquid assets (i.e. cash, gold and unencumbered approved securities).
It is assumed that all the money that goes out of banks is redeposit into the banks.
Let us explain the process of money creation and the measure of money multiplier.
Note that money creation is also called ‘deposit creation’ or ‘credit creation’.
THE PROCESS OF MONEY CREATION
Let us assume that the entire commercial banking system is one unit.
and let us call this one unit simply ‘’BANKS’.
Also assume that all receipts and payments in the economy are routed through the banks.
One who makes payment does it by writing cheque. The one who receives payment deposits the same in his deposit account.
Suppose initially people deposit ₹ 10000. The banks use this money for giving loans. But the banks cannot use the whole of deposit for this purpose. It is legally compulsory for the banks to keep a certain minimum fraction (Percentage of deposits) of these deposits as cash. The fraction is called the Legal Reserve Ratio (LRR). The LRR is fixed by the central bank.
Why are the banks required to keep only a fraction of deposits as cash reserves?
What will banks do if the demand for cash withdrawn is more than cash reserves at some point of time?
There are two reasons:
First the banking experience has revealed that not all depositors approach the banks for withdrawal of money at the same time, and also that normally they withdraw a fraction of deposits.
Secondly, there is a constant flow of new deposits for withdrawal of cash, it is sufficient for banks to keep only a fraction of deposits as cash reserve.
Let us now explain the process.
Suppose the initial deposits in banks is Rs. 10000 and the LRR is 20 percent. Further, suppose that banks keep only the minimum required i.e. Rs. 2000 as a cash reserve, no more no less – Banks are now free to lend the remainder Rs. 8000.
Suppose they lend Rs. 8000.
What banks do is to open deposit accounts in the names of the borrowers who are free to withdraw the amount whenever they like.
Suppose they withdraw the whole of amount for making payments.
Now, since all the transactions are routed through the banks, the money spent by the borrowers comes back into the banks into the deposit accounts of those who have received this payment.
This increases demand deposits in banks by Rs. 8000. It is 80 percent of the initial deposit.
These deposits of Rs. 8000 have resulted on account of loans given by the banks. In this sense the banks are responsible for money creation. With this round increase in total deposits is now Rs. 18000 (=10000+8000).
When banks receive new deposit of Rs. 8000, they keep 20 percent of it as cash reserves and use the remaining Rs. 6400 for giving loans.
The borrowers use these loans for making payments. The money comes back into the accounts of those who have received the payments.
Bank deposits again rise, but by a smaller amount of Rs. 6400. It is 80 percent of the last deposit creation.
The Total deposits now increase to Rs. 24400 (=10000+8000+6400).
The process does not end here.
The deposit creation continues in the above manner. The deposits go on increasing round after round but each time only 80 percent of the last round deposits.
At the same time cash reserves go on increasing, each time 80 percent of the last cash reserve.
The deposit creation comes to end when total cash reserves become equal to the initial deposit. The total deposit creation comes to ₹ 50000, five times the initial deposit.