Credit Creation by Commercial Banks

• Banks are financial intermediaries who accept deposits from those who save and
advance loans to those who invest.
• To illustrate the process of Credit creation by commercial banks, consider an
example.
• Mr. Goyal puts ₹1,000 as a deposit with, say, the SBI.
• The Balance sheet of SBI would then look like this.
Liabilities Assets
Deposits ₹ 1,000 Reserves ₹ 1,000

• The SBI is on a fractional reserve system, with a fraction of, say 20 percent.
• Note that this 20 percent has to meet with, both, the cash reserve requirements
condition as well as the need for excess reserves.
• The SBI will be eager to advance loan in the amount of ₹ 800,retaining ₹ 200 as
reserves to meet the stipulated 20 percent requirement.
• Therefore, when a borrower (Mr. Desai) comes, the SBI will advance a loan of ₹ 800,
and its balance sheet then would change to:
Liabilities Assets
Deposits ₹ 1,000 Reserves ₹ 200
Loans ₹ 800

• Mr. Desai has ₹ 800 in currency. He will spend ₹ 800 on buying some goods/services
from, say, Mr. Patel, who in turn, would deposit the proceeds with the SBI or some
other bank, say, CBI.
• The CBI would keep ₹ 160 ( 20 percent of ₹ 800) in reserves and advance loan in the
remaining amount to , say, Mr. Shah.
• The CBI balance sheet would then look like this
Liabilities Assets
Deposits ₹ 800 Reserves ₹ 160
Loans ₹ 640
• Mr Shah has now ₹ 640 in currency, besides deposits worth ₹ 1,000 with the SBI and ₹
800 with the CBI.
• Thus the money supply is further up by ₹ 640. Mr. Shah may then spend his loan
proceeds on buying goods from, say, Mr. Shukla, who will in turn, go and deposit the
amount with his bank, which could be the SBI, the CBI or a third bank, say, IDFC.
• The recipient bank will keep 20 percent of the new deposit in reserves and advance a
loan from remaining amount to some borrower, say, Mr. Gandhi. Consequently, Mr.
Gandhi will have cash of
₹ (640)(1 – 0.2) = ₹ 512
With the total bank deposits in the amount of : ₹ 1,000(SBI) + ₹ 800(CBI) + ₹ 640 (IDFC)
• Thus, the money supply is again up by ₹ 512. This process goes on and on.
• Although this process of money creation can continue for ever, it does not create an
infinite amount of money.
• Since money creation reduces at every stage, it tends towards zero at some stage,
• The total money supply creation would be given by:

Deposit Multiplier = 1 / Required Reserve Ratio

• Note that the above description assumes:

- No leakage of cash from the system
- Fixed reserve ratio maintained by banks
 Monetary Policy in India
1) Objective of the Monetary Policy: -
• To retain price stability while considering the goal of growth (Primary and most important)

• Regulation, Supervision, and Development of Financial Stability

• Promoting Priority Sector (In India, the priority sector includes agriculture, export, small-scale
enterprises, and the weaker section of the population.)

• Employment Generation

• External Stability

• Encouraging Savings and Investments

• Regulation of NBFIs
2) Monetary Policy Instruments: -
There are numerous direct and indirect instruments used for executing monetary policy,
which are as follows:
• Repo Rate: The fixed interest rate at which the RBI provides to lend instant money to
banks against the government security and other approved collaterals under the liquidity
adjustment facility (LAF).

• Reverse Repo Rate: The fixed interest rate at which the RBI absorbs liquidity, on an
instant basis, from banks against the security of eligible government securities under the
LAF.

• Liquidity Adjustment Facility (LAF): A liquidity adjustment facility (LAF) is a tool used in
monetary policy, which enables banks to borrow money through repurchase agreements
(repos) or banks to lend to the RBI using reverse repo contracts.
• Marginal Standing Facility (MSF): - MSF rate is the rate at which banks borrow funds overnight from the
Reserve Bank of India (RBI) against approved government securities. Under the Marginal Standing Facility
(MSF), currently banks avail funds from the RBI on overnight basis against their excess statutory liquidity
ratio (SLR) holdings.

• Bank Rate: - Bank rate is the rate charged by the central bank for lending funds to commercial banks.

• Cash Reserve Ratio (CRR): The average day-to-day balance a bank is required to sustain with the RBI as a
share of such per cent of its net demand and time liabilities (NDTL).

• Statutory Liquidity Ratio (SLR): The share of NDTL a bank is required to retain in safe and liquid assets,
largely as government securities.

• Open Market Operations (OMOs): Open market operations (OMO) refers to a central bank buying or selling
short-term Treasuries and other securities in the open market in order to influence the money supply.
 Channels of monetary transmission
• There are various channels through which monetary policy influences the real economy.
• These channels basically differ in how monetary policy shocks affect aggregate demand
through different economic and financial variables.
• Depending on the relative importance of a particular economic/financial variable in the
transmission process, the channels are named
A) Interest Rate Channel: -

It simply depicts that reduction in money supply (M) sequentially leads to rise in interest
rate (r), discourages investment (I), and finally reduces the real output (Y) and prices (P).
B) Exchange Rate Channel: -
- The exchange rate channel is related to the above “ interest rate channel”.
- However, working of this channel requires adoption of a flexible exchange rate regime,
and considerable global integration of the concerned economy, both in terms of foreign
trade and investments.
- If the domestic interest rate rises , the domestic assests provide a relatively higher return as
compared the foreign assets.
- This lead to higher foreign investment inflows, and consequently greater availability of foreign
currency in the domestic economy, results appreciation of the domestic currency.
- With appreciation of exchange rate of the domestic currency, export become expensive for foreign
buyers and import become cheaper for domestic buyers.
- In net, exports over the imports (net exports) fall,
- Thus, aggregate demand which includes “net exports” as one of its components falls, leading to
reduction in real output and prices.
C) Asset Price Channel: -
- The “ Asset price channel” is also related to the “ interest rate channel”.
- There are two ways two explain this channel.
1. Related to Tobin’s Q and investment decision.
2. Related the “wealth effect” and consumption expenditure.
1. Related to Tobin’s Q and investment decision: -

- With monetary tightening, the availability of money becomes inadequate as compared to

money demand.
- Scarcity of money in the entire financial portfolio of the public as compared other forms of
assets including equity will lead to selling out of the other assets in the adjustment process.
- Selling of equity stocks will depress equity prices ( Pe ), thus reducing the market value of the
firms.
- This is in turn reduces the Tobin’s Q ( which is the ratio between the market value of the firm
divided by the replacement cost of capital).
- Thus, relatively, the replacement cost of the capital for the firms become more expensive as
compared to the value of the respective firms, in the equity market. This will discourage firm
to install new capital or undertake investment activity by selling some equity.
- Fall in investment will lead to reduction in real output and prices, as explained earlier.
2. Related the “wealth effect” and consumption expenditure: -

- As explained above, monetary contraction leads reduction in asset prices.

- Through the phenomenon of “wealth effects” fall in asset prices results in reduction of
consumption expenditure ( C ).
- As consumption is the dominant component of aggregate demand, this in turn leads to fall in
real output and prices.

D) Bank Lending Channel: -

- The “Bank lending channel” depicts the traditional explanation on how monetary policy works.
- Under this channel, it is assumed that monetary contraction leads to fall in bank deposits.
- Contraction of bank deposits due to monetary tightening, thus, constraints fund availability to
banks for lending, and hence, will reduce the bank lending.
- Lack of access to market for funds for them compels in withholding their investment activities.
- This is turn leads to reduction in real output and prices as explained earlier.
 Quantity Theory of Money
The quantity theory of money states that the general price level of goods and services is
directly proportional to the amount of money in circulation, or money supply.

MV = PQ
Where, M = Money Supply
V = Velocity of Money
P = Prevailing Price Level
Q = Quantity of goods and services produced in the economy
- If the supply of money in an economy doubles, QTM predicts that price levels will also
double.
- Examples: - Suppose, M = ₹ 2000, V = 2 and Q = 500
P = MV / Q
= 2000*2 / 500
P =₹8
• Now money supply is doubled-
M = ₹ 4000, V = 2 and Q = 500
P = 4000*2 / 500
P = ₹ 16