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Money and Banking — Economics STD 12 Commerce — Question

CBSE BoardEnglish MediumSTD 12 CommerceEconomicsMoney and Banking4 Marks
Question
Explain money creation function of commercial banks.
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Answer

Money creation refers to the deposit or credit creation by commercial banks as some multiple of initial deposit, depending upon the reserve requirements. Suppose initial deposit is Rs 1000 crore and legal reserve ratio(LRR) is 0.2 Banks keep Rs 200 crore as reserve and lend the remaining Rs 800 crore. Borrowers spend this money. Those who receive the money from borrowers redeposit into banks.This leads to a fresh deposit of Rs 800 crore.Banks again keep 20 percent as reserves and lend the rest Rs 640 crore which ultimately leads to a fresh deposit of Rs 640 crore. In this way new deposit go on being created round by round leading to total deposit creation of Rs 5000 crore which 1/LRR times i.e. 1/0.2 or 5 times.

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