How do Commercial Banks create credit? Explain with the help of an example.

Money creation (or deposit creation or credit creation) by the banks is determined by (i) the amount of the initial fresh deposits and (ii) the Legal Reserve Ratio (LRR), the minimum ratio of deposit legally required to be kept as liquid assets by the banks. It is assumed that all the money that goes out of banks is redeposited into the banks. Let the LRR be 20% and there is fresh deposits of Rs.10,000. As required the bank keep 20% i.e., Rs.2000 as reserves. Suppose the bank lend the remaining Rs.8,000. Those who borrow, use this money for making payment. As assumed those who receive payments, put the money back into the banks. In this way, banks receive fresh deposits of Rs.8,000. The banks again keep 20% i.e. Rs.1600 as reserves and lend Rs.6,400, which is also 80% of the last deposit. The money again comes back to the banks leading to a fresh deposit of Rs.6,400. The money goes on multiplying in this way, and ultimately total money creation is Rs.50,000.

Given the amount of fresh deposit and the LRR, the total money creation is:

Total Money Creation = Initial Deposits x 1/LRR

(i) Buying and selling of government securities in the market is known as open market operations.

(ii) Open market operations have an impact on the lending capacity of the banks. 

(iii) It is an important means of controlling the money supply. 

(iv) During inflation or excess demand situation the main motive of the Central Bank is to reduce the money supply. To suck excess liquidity from the market the Central Bank sells bonds, government securities and treasury bills. 

(v) Due to low money supply, there is a fall in the volume of investment, income and employment resulting in lower demand. 

(vi) During deflation, the main motive of the Central bank is to increase the money supply and to increase the money supply the Central Bank buys bonds, government securities and treasury bills.