Understanding Deposit Creation by Commercial Banks

Commercial banks play a crucial role in the economy by creating credit or deposits. This process is known as deposit creation or money creation. It is based on the fact that banks are required to keep only a fraction of their deposits as reserves with the central bank, known as the Cash Reserve Ratio (CRR), and the rest can be lent out.

The Money Multiplier Concept

The extent to which commercial banks can create deposits is determined by the money multiplier. The money multiplier indicates how much the total money supply can increase for every unit increase in the monetary base (like a primary deposit). It is inversely related to the Cash Reserve Ratio (CRR).

The formula for the money multiplier is:

\( \text{Money Multiplier} = \frac{1}{\text{CRR}} \)

The total deposits created in the banking system as a result of an initial primary deposit can be calculated using the formula:

\( \text{Total Deposits} = \text{Primary Deposit} \times \text{Money Multiplier} \)

Applying the Concepts to the Problem

We are given the following information:

• Primary Deposit = ₹20 Crores
• Cash Reserve Ratio (CRR) = 20%

First, we need to convert the CRR percentage into a decimal:

\( \text{CRR} = 20\% = \frac{20}{100} = 0.20 \)

Next, we calculate the Money Multiplier using the formula:

\( \text{Money Multiplier} = \frac{1}{\text{CRR}} = \frac{1}{0.20} \)

\( \text{Money Multiplier} = 5 \)

This means that for every ₹1 of primary deposit, the banking system can create ₹5 of total deposits.

Finally, we calculate the total deposits created by multiplying the primary deposit by the money multiplier:

\( \text{Total Deposits} = \text{Primary Deposit} \times \text{Money Multiplier} \)

\( \text{Total Deposits} = ₹20 \text{ Crores} \times 5 \)

\( \text{Total Deposits} = ₹100 \text{ Crores} \)

Therefore, when the primary deposit is ₹20 Crores and the cash reserve ratio is 20%, the total deposits made by commercial banks are ₹100 Crores.

Revision Table: Key Concepts

Additional Information on Deposit Creation

The process of deposit creation assumes a simplified model where banks lend out all excess reserves and all money lent out returns to the banking system as deposits. In reality, the actual money multiplier might be smaller due to factors like:

• People holding some cash instead of depositing it all back into banks.
• Banks holding reserves above the required CRR (excess reserves).
• The presence of the Statutory Liquidity Ratio (SLR), which requires banks to hold a certain percentage of their deposits in liquid assets other than cash with the central bank.

The Cash Reserve Ratio (CRR) is a significant tool used by the central bank to control the money supply and credit in the economy. By changing the CRR, the central bank can influence the money multiplier and thus the lending capacity of commercial banks.