Central bank an apex institution for all commercial banks. An important source of money supply,Banker to the govt.,Bankers' bank and supervisory role,Iender of the last resort,custodian of foreign exchange and credit controller. It accepts deposits from the commercial banks and advances loans to them. But, it does not deal with the general public. Whereas a commercial bank is that financial institution which accepts deposits from the general public and offers loans to the people for purpose of consumption and investment. A commercial bank only contributes to the supply of money by way of credit creation as follows.
We assume that:
i) There is a 'single banking system'in
the economy and initially, the banks receive deposits of Rs. 1,000.
ii) CRR = 10% and it does not change. This reflects cash reserves of the commercial banks as a percentage of their demand deposits. Just see the table below:
Creation of money
Rounds Deposits Loans cash
(Rs.) (Rs.) 10%
Ist 1,000 900 100
2nd 900 810 90
3rd 810 729 81
(and so till all excess reserve are exausted)
Total 10,000 9,000 1,000
# In the first round, bank receives deposits of Rs. 1,000.
# The cash reserves to tackle the liability of Rs. 1,000 is equal to Rs. 100. Implying that the banks have excess reserves = Rs.1,000 - Rs. 100 = Rs. 900 which they can use for the purpose of lending.
# When these excess reserves are loaned out, deposits of the banks are raised by Rs. 900. The bank need to hold cash reserves as 10% of Rs. 900 or Rs. 90.Now, excess reserves of the bank is Rs. 900 - Rs. 90 = Rs. 810 which can be loaned. This process continues till total demand deposits are Rs. 10,000 and cash reserves are Rs. 1,000.
Thus, if cash reserve ratio is equal to 10% , initial deposits of Rs. 1,000 allows the bank to create demand Deposits up to Rs. 10,000. so that
Demand Deposits = 1/CRR × Cash Res.
= 1/10% × 1,000
= 10 × 1,000 = 10,000.
Thus, commercial bank has created Rs. 10,000 from Rs. 1,000.
By- Ms. Neeraj Khanna
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