How does a commercial bank create money? - Vidyadip

Question

How does a commercial bank create money?

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Answer

Money creation by banks is determined by (1) Fresh deposits and (2) Legal Reserve Ratio. Suppose fresh deposit is Rs. 10000 and LRR is 20%. Initially banks keep Rs. 2000 as cash and lend Rs. 8000. Those who borrow spend this Rs. 8000. It is assumed that this Rs. 8000 comes into banks as a fresh deposit. Banks again keep 20% of it as cash reserve and lend the rest. In this way money creation goes on. Total money creation is Rs. 50000.

$\text{Money creation} = \text{initial deposit}\times\frac{1}{\text{LRR}}.$

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