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Giving a numerical example, explain the process of money creation by the commercial banks. Or Government of India has launched 'Jan-Dhan Yojana' aimed at every household to have at least one bank account due to which credit creation capacity of banks have seen expansion manifolds. Comment.

Answer:

Ans.     Money creation (or deposit creation or credit creation) by the banks is determined by (i) The amount of the initial fresh deposits and (ii) Legal Reserve Ratio (LRR) i.e. the minimum ratio of deposit, legally required to be kept as cash by the banks. It is assumed that all the money that goes out of the banks, is re-deposited into the banks. Let the LRR be 20% and there is a fresh deposit of Rs.10,000. As required, the banks keep 20 %, i.e. Rs. 2,000 as cash. Suppose the banks lend the remaining Rs. 8,000. Those who borrow, use this money for making payments. As assumed, those who receive payments, put the money back into the banks. In this way, banks receive fresh deposits of Rs. 8,000. The banks again keep 20%, i.e. Rs. 1,600 as cash and lend Rs. 6,400, which is also 80% of the last deposits. The money again comes back to the banks leading to a fresh deposit of Rs. 6,400. The money goes on multiplying in this way and ultimately total money creation is Rs. 50,000. Given the amount of fresh deposit and the LRR, the total money creation is Total Money Creation=Initial Deposit\[\times \frac{1}{LRR}\]                                     Or With the introduction of 'Jan- Dhan Yojana', many households have opened bank account. Due to this, primary deposits of commercial banks have increased. Banks create credit on the basis of primary deposits. Higher the primary deposits, higher is the credit creation capacity of commercial banks and vice-versa. With implementation of 'Jan-Dhan Yojana', since primary deposits have increased, reserves of bank to create credit have also swollen up. Therefore, credit creation capacity of commercial banks is increased manifolds.