Answer to Question #275490 in Macroeconomics for Kirti

Question

Explain the process of credit creation in the economy and indicate the relationship between the reserve ratio and money multiplier

Answer 1

a)Process of credit creation in the economy

People deposit money in their respective bank accounts. As per the central bank guidelines, the commercial banks are required to maintain a portion of total deposits in form of cash reserves. With the help of the past experiences, the commercial banks know that not all the depositor will turn-up for withdrawal at the same day. Consequently, the commercial banks lends the remaining portion (left after maintaining cash reserves) of the total deposits to the general public in form of credit, loans and advances. It is the second portion of the total deposits that is responsible for the credit creation (credit money). The process of creation of credit money begins as soon as the commercial banks start the lending process. The amount of the credit money increases as the banks lend loans to more and more number of people in the economy. The deposit of money by the people in the banks and the subsequent lending of loans by the commercial banks is a never-ending process. It is due to this continuous process that the commercial banks are able to create credit money a multiple times of the initial deposits.

b) Relationship between the reserve ratio and money multiplier

The Money Multiplier refers to how an initial deposit can lead to a bigger final increase in the total money supply while reserve ratio is the percentage of deposits that banks keep in liquid reserves.

The relationship between them is depicted in the formula below:

$Money multiplier=\frac{1}{reserve ratio}$