Model Answer
0 min readIntroduction
Commercial banks play a pivotal role in modern economies, not merely as intermediaries but as active creators of credit. This ability stems from the fractional reserve banking system, where banks are required to hold only a fraction of deposits as reserves and can lend out the rest. This process of lending and re-depositing leads to a multiple expansion of initial deposits, a phenomenon known as credit creation. This credit creation is intrinsically linked to the multiplier effect, influencing aggregate demand and economic activity. Understanding this mechanism is crucial for effective macroeconomic policy formulation.
Credit Creation by Commercial Banks: The Mechanism
The process of credit creation can be explained through two main mechanisms: primary and secondary deposits.
Primary Deposits
When individuals or firms deposit money into a commercial bank, it constitutes a primary deposit. The bank is legally obligated to maintain a certain percentage of these deposits as reserves, known as the Cash Reserve Ratio (CRR), mandated by the Reserve Bank of India (RBI). The remaining portion can be used for lending.
Secondary Deposits
When the bank lends out the excess reserves, the borrower typically deposits this loan amount into another bank (or even the same bank). This creates a secondary deposit. Again, the receiving bank keeps a fraction as reserves (CRR) and lends out the rest. This process continues, leading to a multiple expansion of the initial deposit.
The credit multiplier (or money multiplier) determines the maximum amount of credit that can be created from an initial deposit. It is calculated as: 1/Reserve Ratio (where Reserve Ratio includes CRR and Statutory Liquidity Ratio - SLR). For example, if the CRR is 4% and SLR is 18%, the reserve ratio is 22% (0.22). The credit multiplier would be approximately 1/0.22 = 4.55. This means an initial deposit of ₹100 can potentially lead to a total increase in money supply of ₹455.
The Multiplier Effect
The multiplier effect describes the magnified impact of an initial injection of spending (investment, government expenditure, or exports) on the overall level of national income. The credit creation process by banks fuels this effect. When banks create credit, it increases the money supply, leading to increased investment and consumption. This increased demand leads to higher production, employment, and income. The resulting increase in income further boosts demand, creating a chain reaction.
The size of the multiplier is determined by the Marginal Propensity to Consume (MPC). The multiplier (k) is calculated as: k = 1/(1-MPC). A higher MPC leads to a larger multiplier, meaning a greater impact on national income from an initial injection of spending. For instance, if MPC is 0.8, the multiplier is 1/(1-0.8) = 5. Therefore, a ₹100 increase in investment will lead to a ₹500 increase in national income.
Limitations to the Multiplier Effect
While the multiplier effect is a powerful concept, several factors can limit its impact and jeopardize the implications of credit creation:
- Leakages: These reduce the amount of spending that recirculates in the economy.
- Savings: If individuals save a larger portion of their income instead of spending it, the multiplier effect is reduced.
- Imports: Spending on imports represents a leakage as it directs demand towards foreign economies.
- Taxes: Government taxes reduce disposable income, limiting consumption and investment.
- Excess Capacity: If the economy is operating near full capacity, increased demand may lead to inflation rather than increased output.
- Liquidity Trap: In a liquidity trap, individuals and firms hoard cash despite low interest rates, rendering monetary policy ineffective and diminishing the multiplier effect.
- Expectations: Pessimistic expectations about future economic conditions can discourage investment and consumption, even with increased credit availability.
- RBI’s Monetary Policy: The RBI can influence the credit creation process through tools like CRR, SLR, and repo rates. Tightening monetary policy can curb credit growth and dampen the multiplier effect.
Example: During the Global Financial Crisis of 2008, despite significant monetary easing by central banks, the multiplier effect was weak due to high levels of uncertainty, deleveraging, and a collapse in consumer confidence. This highlights the importance of psychological factors and financial stability in determining the effectiveness of monetary policy.
| Factor | Impact on Multiplier |
|---|---|
| High Savings Rate | Reduces the multiplier |
| High Import Dependence | Reduces the multiplier |
| Full Capacity Utilization | Leads to Inflation, limits output increase |
| Tight Monetary Policy | Reduces credit creation, dampens multiplier |
Conclusion
In conclusion, commercial banks’ credit creation mechanism, driven by the fractional reserve system, is a fundamental driver of the multiplier effect and overall economic activity. However, the actual impact of this process is contingent upon various factors, including leakages, economic capacity, and prevailing expectations. Policymakers must carefully consider these limitations when formulating monetary and fiscal policies to maximize the effectiveness of credit creation and achieve sustainable economic growth. A nuanced understanding of these dynamics is essential for navigating the complexities of modern economies.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.