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Commercial Banks deals with credit..They create credit by its loan operations, advances and investments..through credit creation commercial banks are able to support economy..
The process where banks create credit by issuing out loans to businesses and customers from increased demand deposits. A portion of those deposits is kept by the bank as reserve.
credit creation is the multiple expansion of bank demand deposits
Bank keeps a certain percentage of deposit in cash as reserve the remaining is basically the credit creation or you can say the expansion of bank deposits through the process of more loans and advances and investment.
Credit creation refers to the ability of a bank to expand deposits as a multiple of its reserves. A bank keeps a certain proportion of its deposits as minimum reserve for meeting the demand of the depositors and lends out the remaining excess reserve to earn income. The bank loan is not paid directly to the borrower but is only credited into his/her account. Every bank loan creates an equivalent deposit in the bank. Thus credit is created by expanding deposits as a multiple of its reserves.
The most important function of a commercial bank is to create deposits either to open a bank account by the new customer(s) or to lend the money to their customer(s). For lending the loan to customers, bank create a current account and transfer the loan amount in it, thus creating a credit or deposit account. The bank earn from this account in the form of markup from the loaners.
Credit Creation is a situation in which banks make more loans to consumers and businesses, with the result that the amount of money in circulation(being passed from one person to another) increases.
In other words it refers to the unique power of the banks to multiply loans and advances, and hence deposits.
The process of credit creation
Suppose a man, say A, deposits $2,000 with a bank and the LRR is10%, which means the bank keeps only the minimum required $200 as cash reserve (LRR). The bank can use the remaining amount $1,800 (=2000 –200) for giving loan to someone. (Mind, loan is never given in cash but it is redeposited in the bank as demand deposit in favour of borrower.) The bank lends $1800 to, say, Y who is actually not given loan but only demand deposit account is opened in his name and the amount is credited to his account.
This is the first round of credit creation in the form of secondary deposit ($1,800), which equals90% of primary (initial) deposit. Again10% of Y’s deposit (i.e., $180) is kept by the bank as cash reserve (LRR) and the balance $1,620 (=1,800 –180) is advanced to, say, Z. The bank gets new demand deposit of $1,620. This is second round of credit creation which is90% of first round of increase of $1,800. The third round of credit creation will be90% of second round of1620. This is not the end of story.
The process of credit creation goes on continuously till derivative deposit (secondary deposit) becomes zero. In the end, volume of total credit created in this way becomes multiple of initial (primary) deposit. The quantitative outcome is called money multiplier. If the bank succeeds in creating total credit of, says $18,000, it means bank has created9 times of primary (initial) deposit of $2,000. This is what is meant by credit creation.
In short, money (or credit) creation by commercial banks is determined by (i) amount of initial (primary) deposits and (ii) LRR. The multiple is called credit creation or money multiplier.
Multiple expansion of deposits is called credit creation.Demand deposits are the main source of credit creation. When a banks deposits increases it will have more fund to lend in the market.
Customer deposited money to Bank. It is for Bank Credit creation. A credit creation is the multiple expansion of bank demand deposits.
