Limits To Credit Creation and Money Multiplier

Credit Creation ability is an attribute that distinguishes a bank from other financial entities. Expanding deposits may be thought of as creating credit. In addition, as demand deposits are the main form of trade, banks may increase their demand deposits by a multiple of their cash holdings.

The Reserve Bank of India (RBI), or the central bank, can restrict how much money or credit banks may create. Every bank must maintain reserves at a certain level, which the RBI sets. To prevent any bank from overlending, this is done.

Credit Creation Meaning

Credit creation refers to the process by which banks and financial institutions generate new money in the economy through the issuance of loans and credit. When a bank provides a loan or extends credit to a borrower, it creates a new deposit in the borrower's account. This deposit, which represents a liability for the bank, can then be used by the borrower for spending and other financial transactions. Credit creation is crucial in expanding the money supply and overall economic activity.

What is the Money Multiplier?

The money multiplier is a concept in economics that illustrates the potential increase in the money supply resulting from a change in the monetary base, typically initiated by central banks. It is derived from the fractional reserve banking system, where banks are required to hold only a fraction of their deposits as reserves and can lend out the remaining amount. The money multiplier quantifies the overall expansion of the money supply through this lending process, reflecting the ratio of the change in the money supply to the change in the monetary base.

Importance of Credit Creation and Money Multiplier

Credit creation and the money multiplier play crucial roles in the modern monetary system, influencing economic activity, liquidity, and financial stability. Below are a few points that shed light on how these mechanisms contribute to the broader functioning of economies.

1. Economic Growth:

Credit creation fuels borrowing, investment, and spending, which drive economic expansion and job creation.

2. Money Supply Expansion:

The money multiplier leads to the multiplication of the initial monetary base, ensuring sufficient money supply to support economic transactions.

3. Financial Intermediation:

Credit creation facilitates the flow of funds from savers to borrowers through the banking system, promoting efficient allocation of resources.

4. Investment and Innovation:

Credit creation encourages businesses to invest in projects and innovations that drive technological progress and enhance productivity.

5. Liquidity and Spending:

The money multiplier supports the availability of liquid assets, enabling individuals and businesses to engage in transactions and consumption.

6. Financial System Stability:

Responsible credit creation and prudent money multiplier management contribute to a stable banking system and reduced financial risks.

Limits to Credit Creation and Money Multiplier

While credit creation and the money multiplier mechanism are essential components of the modern banking system, it is crucial to acknowledge the inherent limits that can impact their effectiveness.

1. Reserve Requirements:

The requirement for banks to hold a portion of their deposits as reserves limits the extent to which they can lend and create credit.

2. Deposit and Loan Demand:

Individuals and businesses' willingness to deposit money and borrow affects the actual expansion of credit and the money supply.

3. Central Bank Influence:

Central bank policies, such as changes in interest rates or monetary regulations, can impact the willingness of banks to lend and individuals to borrow.

4. Borrower Creditworthiness:

The creditworthiness of borrowers affects the volume of loans granted by banks, influencing the money multiplier effect.

5. Economic Conditions:

Economic instability or uncertainty can impact borrowing and spending behavior, affecting the effectiveness of credit creation and the money multiplier.

6. Global Interactions:

In an interconnected world, international capital flows and exchange rates can influence the amount of credit creation and the money multiplier's impact.

7. Regulatory Measures:

Government regulations and supervisory actions can influence banks' lending practices, affecting the expansion of credit and the money multiplier.

Credit Creation Example

Introducing Raj, a diligent saver, and Mumbai Savings Bank, a local bank in the bustling city.

Step 1: Raj's Savings Deposit

Raj decides to save ₹10,000 in his account at Mumbai Savings Bank. This ₹10,000 is Raj's hard-earned money that he plans to keep safe in his savings account.

Step 2: Bank's Reserve Requirement

Mumbai Savings Bank needs to keep a fraction of its deposits as reserves. Assuming a reserve requirement of 10%, the bank must retain ₹1,000 (10% of ₹10,000) as reserves and can lend out the remaining ₹9,000.

Step 3: Priya's Small Business Loan

An enterprising entrepreneur, Priya approaches Mumbai Savings Bank for a loan to expand her boutique. She requires ₹9,000 to purchase new fabrics and hire an additional tailor. The bank reviews Priya's business proposal and grants her the loan.

Step 4: Money in Motion

The bank transfers ₹9,000 to Priya's business account. Now, Priya has ₹9,000 in her account, which she promptly uses to buy fabrics and pay her new tailor. The fabric supplier and tailor both deposit their payments in their respective bank accounts- let's call them Mumbai Fabrics Bank and Craftsmen Cooperative Bank.

Step 5: Mumbai Fabrics Bank and Craftsmen Cooperative Bank

Mumbai Fabrics Bank and Craftsmen Cooperative Bank, where the payments were deposited, are also subject to the 10% reserve requirement. This means:

• Mumbai Fabrics Bank holds ₹900 (10% of ₹9,000) as reserves and lends out ₹8,100 to another local business.
• Craftsmen Cooperative Bank retains ₹900 (10% of ₹9,000) as reserves and lends out ₹8,100 to a person looking to buy a scooter.

Step 6: Ripple Effect

The cycle continues. The business borrowed from Mumbai Fabrics Bank invests in new equipment, and the supplier deposits the money in another bank. The person who got a loan from Worker's Choice Bank buys a car, and the car dealer's bank receives the deposit.

This chain reaction keeps going as money is lent, spent, and deposited, and each time, a portion is kept as reserves, allowing for more loans and spending.