What is Money Creation by Commercial Banks Class 12: Explained Simply

Definition of Money Creation by Commercial Banks

Money creation by commercial banks is the process through which banks generate new money by accepting deposits and providing loans. When a bank receives a deposit, it keeps a part as reserves and lends out the rest. This lending creates new deposits in other banks, increasing the total money supply.

In Class 12 Economics, NCERT defines money creation as the ability of commercial banks to create money beyond the initial cash deposited. It is a key function of banks that supports economic growth by increasing liquidity.

How Do Commercial Banks Create Money? The Process Explained

The money creation process by commercial banks involves several steps:

• A customer deposits money in a bank.
• The bank keeps a fraction as reserves (called the reserve ratio).
• The remaining amount is lent to borrowers.
• Borrowers spend this money, which gets deposited in other banks.
• These banks again keep a fraction as reserves and lend the rest.

This cycle continues, multiplying the initial deposit into a larger money supply.

Example: If the reserve ratio is 10%, and ₹1,000 is deposited:

• Bank keeps ₹100 as reserves.
• Lends ₹900 to borrowers.
• ₹900 is deposited in another bank, which keeps ₹90 and lends ₹810.

This process repeats, creating more money than the original ₹1,000.

The Role of Reserve Ratio in Money Creation

The reserve ratio (also called cash reserve ratio or CRR) is the percentage of deposits that banks must keep as reserves and not lend out. It directly affects how much money banks can create.

• Lower reserve ratio: Banks can lend more, increasing money creation.
• Higher reserve ratio: Banks lend less, reducing money creation.

Formula for Money Multiplier:

$$ ext{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}$$

If the reserve ratio is 0.1 (10%), the money multiplier is 10, meaning every ₹1 deposited can create ₹10 in the economy.

Deposit Multiplier and Its Formula

The deposit multiplier shows how initial deposits lead to a multiplied increase in total money supply.

Formula:

$$\text{Total Money Created} = \text{Initial Deposit} \times \text{Money Multiplier}$$

Worked Example:

If the initial deposit is ₹5,000 and the reserve ratio is 20% (0.2):

• Money Multiplier = $\frac{1}{0.2} = 5$
• Total Money Created = ₹5,000 × 5 = ₹25,000

Thus, ₹5,000 deposited can create ₹25,000 in the banking system.

Comparison: Money Creation vs. Money Supply

Understanding the difference between money creation by banks and overall money supply is important.

Money creation is a component that influences the broader money supply.

Importance of Money Creation in the Indian Economy

Money creation by commercial banks plays a crucial role in India's economic development:

• Supports economic growth: By providing loans, banks fund businesses and consumers.
• Controls inflation: RBI adjusts reserve ratios to manage money supply.
• Promotes liquidity: Ensures enough money circulates for trade and investment.
• Impacts monetary policy: RBI uses money creation data to set interest rates.

For Class 12 students, understanding this concept helps explain how banks influence the economy beyond just safekeeping money.