Credit creation

Also called: Money creation, deposit creation · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 12, Ch 3 "Money and Banking"

Meaning

Credit creation is the process in which banks lend out part of their deposits, the loans come back into banks as new deposits, and those deposits are lent again, until total deposits (money) grow to a multiple of the reserves the banks hold.

It explains how commercial banks, and not only the central bank, create most of the money in an economy. It also sets the limit on how much money the RBI's base money can support.

• Simple money multiplier: m = 1/CRR
• Fuller money multiplier (NCERT): m = (1 + cdr)/(cdr + rdr)
• Money supply = m × H, where H is high-powered money (the base money issued by the RBI).

Explanation

How it works: from goldsmith to bank

• Fractional-reserve banking. A bank keeps only a fraction of its deposits as cash (reserves) and lends out the rest.
• Lala the goldsmith (Class 12 NCERT story):
• Villagers keep 100 kg of gold with Lala and get paper receipts. The receipts start to work as money.
• Lala lends 25 kg to Ramu. Ramu pays Ali, and Ali deposits the gold back with Lala.

• Receipts in circulation rise to 125 kg, but the gold is still only 100 kg. Lala has created money by lending.

• The bank balance sheet. A bank balance sheet lists what a bank owns (assets) and what it owes (liabilities).

• Assets = Reserves + Loans. Liabilities = Deposits, because a deposit is money the bank owes to the depositor.
• Reserves = vault cash (cash in the bank's own safe) + the bank's deposits with the RBI. Reserves are not lent.

Worked example (CRR = 20%)

• The Cash Reserve Ratio (CRR) is the minimum share of deposits a bank must keep as reserves.
• Round by round:
• Leela deposits ₹100. The bank keeps ₹20 and lends ₹80 to Jaspal Kaur.
• Jaspal spends the ₹80, and it comes back as a deposit. Deposits are now ₹180.
• Required reserves = 20% of 180 = ₹36. The bank holds ₹100 in cash, so it can lend ₹64 more (to Junaid).
• The process stops when deposits reach ₹500.

Round	Deposits (₹)	Required reserve (₹)	Loan (₹)
1	100	20	80
2	180	36	64
Last	500	100	400 (total)

• Why ₹500? The new deposits form the series 100 + 80 + 64 + 51.2 + …, a geometric series with ratio r = 0.8 (that is, 1 − CRR).
• Sum = 100 × 1/(1 − 0.8) = 100 × 5 = ₹500.

• So m = 1/0.2 = 5, and M1 rises from ₹100 to ₹500.

• NCERT error: the Class 12 appendix sums this series with r = 0.4 and gets 5/3. The correct ratio is r = 0.8, which gives 5.

What makes credit creation rise or fall

• CRR goes up → the multiplier goes down.
• If CRR rises from 20% to 25%, m = 1/0.25 = 4.
• Maximum deposits fall to ₹400, and maximum loans fall from ₹400 to ₹300.

• Banks must call back (recall) ₹100 of loans, so money supply shrinks.

• The public's cash habit (cdr). The currency deposit ratio (cdr) is the cash people hold divided by their bank deposits.

• If people hold more cash, less money comes back to banks to be lent again, so m falls.
• Worked example: cdr = 0.25 and rdr = 0.20 give m = 1.25/0.45 ≈ 2.8, well below the simple 1/0.2 = 5.

• If cdr = 0 (nobody holds cash), then m = 1/rdr, which is the simple formula.

• Banks' extra reserves (rdr). The reserve deposit ratio (rdr) is required reserves plus any extra cash banks choose to keep, as a share of deposits. A higher rdr means a smaller multiplier.

• Supply of H. Banks can only multiply the base money that the RBI supplies. They cannot create H themselves.
• Demand for loans. Banks cannot lend if firms and households do not want to borrow.

In India

• Who controls the base. The RBI supplies high-powered money (M0, also called reserve money or monetary base).
• M0 = currency in circulation + bankers' deposits with RBI + other deposits with RBI.

• M0 grows when the RBI's net credit to government, its credit to banks (for example repo loans), or its net foreign exchange assets grow. More H allows more credit creation.

• CRR rule. CRR is the average daily balance a bank must keep with the Reserve Bank, as a per cent of its net demand and time liabilities (NDTL). NDTL roughly means the bank's deposits and similar liabilities to the public [2].

• CRR was cut to 4.0% of NDTL in December 2024 [5]. It now stands at 3.00% [3].

• Banks earn no interest on CRR balances.

• SLR is separate. The Statutory Liquidity Ratio (SLR) requires banks to hold a set share of their liabilities in liquid assets, "typically in unencumbered government securities, cash and gold" [2]. "Unencumbered" means not already pledged for another loan.

• The actual multiplier (2024-25):
• m = M3 ₹272.87 lakh crore ÷ M0 ₹48.3 lakh crore ≈ 5.6.
• Check with the fuller formula: cdr ≈ 0.15 and rdr ≈ 0.046, so m ≈ 1.15/(0.15 + 0.046) ≈ 5.8.

• At a 3% CRR, the simple formula would give about 33. The real figure is only 5–6 because people hold a lot of cash and banks keep vault cash above the CRR. So the fuller formula describes India better.

• Policy rates. The repo rate (the rate at which the RBI lends to banks for a short time) was cut by 50 basis points to 5.50% on 6 June 2025 [2]. Cheaper borrowing from the RBI can support bank lending, and so credit creation.

• Measurement. The RBI has compiled monetary statistics since July 1935. It derives M3 with a balance-sheet approach that combines the balance sheets of the RBI and the banking sector [4].
• Safety net. Because banks keep only a fraction of deposits as reserves, a bank run is always possible. A bank run is when many scared depositors withdraw money at the same time. India's protections are the RBI as lender of last resort and deposit insurance through the DICGC.

Don't confuse with

• High-powered money (M0) creation. Only the RBI creates M0. Commercial banks only multiply it through credit creation.
• CRR vs SLR. CRR is kept with the RBI as cash balances and earns nothing. SLR stays with the bank in G-secs, cash and gold and earns interest [2]. Government securities count towards SLR, not CRR.
• Simple multiplier vs fuller multiplier. 1/CRR assumes the public holds no cash and banks keep no extra reserves. (1 + cdr)/(cdr + rdr) includes both, so it always gives a smaller and more realistic figure.
• Where CRR is kept (NCERT error). NCERT says CRR reserves are kept "with the bank" and include RBI-issued bonds and T-bills. The correct position is that CRR is kept with the RBI, and reserves are only vault cash plus deposits with the RBI [2]. T-bills are government debt that the RBI issues for the Government.

Prelims Hooks

• Simple money multiplier = 1/CRR. CRR 20% → m = 5. CRR 25% → m = 4.
• Fuller multiplier m = (1 + cdr)/(cdr + rdr). A fall in cdr (wider banking habit) raises m.
• Money supply = m × H. In India in 2024-25, m ≈ 5.6 (M3 ₹272.87 lakh crore ÷ M0 ₹48.3 lakh crore).
• Trap: "CRR balances can be held in government securities." False. CRR is kept with the RBI as a % of NDTL. Government securities count towards SLR [2].
• CRR: 4.0% of NDTL (December 2024) [5] → 3.00% now [3].
• The risk built into fractional-reserve banking is a bank run. The remedy is a lender of last resort + deposit insurance.

Mains Points

• The RBI controls money supply only partly.
• The RBI sets H and the CRR.
• The multiplier also depends on how much cash the public holds and on whether people want to borrow.

• So a CRR cut (4% in December 2024 [5] → 3% [3]) gives banks more money to lend, but credit grows only if there is demand for loans. This is why policy cuts can reach the economy only weakly. (GS-III: effectiveness of monetary policy.)

• Financial inclusion strengthens credit creation.

• Jan Dhan accounts and digital payments lower cdr.
• A lower cdr raises the multiplier and keeps more money inside banks, where RBI signals reach it.

• Demonetisation (2016-17) showed the reverse: currency with the public fell sharply.

• Fractional reserves involve a trade-off between growth and safety.

• Low reserves allow more lending and faster growth.
• But they raise the risk of a bank run.
• So credit creation needs prudential rules (CRR, SLR, capital norms), a lender of last resort and deposit insurance (DICGC). (GS-III: financial stability and banking reform.)

Related concepts

• Bank balance sheet
• Bank reserves
• Money multiplier
• Currency deposit ratio
• Reserve deposit ratio
• Bank run
• High-powered money
• Currency in circulation
• Money supply
• M1

Read more

• Credit creation, high-powered money and the money supply