Credit creation

The question arises is that what is the difference between Narrow Money (M₁), Broad Money (M3) and Reserve Money? This is very important question. When we say that Reserve Money is the Real Cash Money held with both the Public and the Banks this means that

RM = C + OD + CR

Where:

• C stands for Currency with Public
  
• OD means other deposits with the RBI
  
• CR means Cash Reserves
  

But by Narrow Money, we refer to

NM (M1) = C + DD

Where

• C stands for Currency with Public
  
• DD means demand deposits.
  

So, we can say that The Reserve Money has the Cash Reserve component of the Banks and other deposits with the RBI and this is the major difference between the RM and M1.

Again,

The Broad Money or M3 is denotes as follows:

BM (M3) = C + OD + DD + TD

Where:

• C stands for Currency with Public,
  
• OD stands for Other Deposits of the public with Banks
  
• DD stands for Demand Deposits
  
• TD refers to Time Deposits.
  

This means that C and OD are common in Broad Money and Reserve Money. The difference is of Cash Reserves.

But what is the relevancy of understanding this comparison?

This comparison is very much relevant. We take this example for understanding this interesting proposition. But before that we have to assume the following:

1. We assume that there is No Reserve bank or any other monetary authority.
   
2. We assume that there are only Demand Deposits.
   
3. We assume that a Bank has no excess reserves
   
4. We also assume that there is no other use of cash than the use mentioned in the following example.
   

Let’s begin:

• We begin with a XYZ Bank. In this Bank Suresh approaches to open a demand deposit of ` 10,000. Once Suresh deposits the money with the Bank, Bank has now ` 10000 with it.
  
• Ramesh comes to the bank to get a loan and he is disbursed a Loan of ` 10000 by the Bank.
  
• Again Ganesh approaches the Bank and deposits ` 10000.
  
• Mohan comes to the Bank for a Loan and he is again disbursed a Loan of ` 10000.
  

The concept in which the commercial Banks expand the deposits and expand their loans and advances is called “Credit Creation”. In the above theoretical example, the XYZ Bank can create unlimited credit. The bank Create Credits because this is source of their income.

But since in the above example, the depositors Suresh and Ganesh come together to get their money back (as these are demand deposits) what the Bank will do?

In other words, a bank may exploit its “Credit Creation” capability and Create Loans many times of the deposits they have with them. This leads to a bubble and probably, if such is the case, the Bank XYZ may fail sooner or later.

The solution of the above is that Bank XYZ is asked to keep a part of all the deposits it gets every time as Cash Reserves or Liquid Reserves , so that it can pay the depositors when the demand their money.

Now we take the same example. Here we assume that the bank as to keep 25% of its deposits as Reserves. So the rounds are as follows:

• Suresh approaches to open a demand deposit of ` 10,000. Once Suresh deposits the money with the Bank, Bank has now ` 10000 with it. Out of this the bank has ` 2500 reserved and now has an excess cash of ` 7500.
  
• Ramesh comes to the bank to get a loan and he is disbursed a Loan of ` 7500 by the Bank.
  
• Again Ganesh approaches the Bank and deposits ` 10000.
  
• Mohan comes to the Bank for a Loan and he is again disbursed a Loan of ` 7500.
  
• The Bank has now ` 5000 with it as reserves.
  
• After two more similar rounds, Bank can pay Suresh the amount if he comes back to get his money.
  

The number of times a bank can create a credit is called Bank Multiplier. It is denoted as follows:

The Required Reserve Ratio of 25% can create a credit equal to 4 times. Similarly a required reserve ratio 20% , the deposit multiplication will be for 5 times.

Now, in India, the Required Reserve Ratio is made up of two components.

• Cash Reserve Ratio : with RBI
  
• Statutory Liquidity Ratio : with themselves
  

RBI increases and decreases these ratios.

“By manipulating the Cash Reserve Ratio and Statutory Liquidity ratio, RBI can influence the total Volume of the Bank credit and Total Volume of the Bank deposits or bank Money in the country”