Credit creation, high-powered money and the money supply

Detail

1. How banking began: Lala the goldsmith (Class 12)

• The deposit. Villagers keep 100 kg of gold with Lala. He gives them paper receipts.
• People start paying each other with these receipts, not with the gold.

• So the receipts start to work as money.

• The loan. Lala sees that depositors rarely all come back for their gold together. So he lends 25 kg to Ramu.

• Ramu pays Ali with this gold.

• Ali deposits the gold back with Lala and gets a receipt.

• Result. Receipts in circulation ("money") rise from 100 kg to 125 kg, but the gold is still only 100 kg.

• Lala has created money by lending.

• This is fractional-reserve banking: a bank keeps only a part (fraction) of its deposits as cash and lends the rest.

• The risk is a bank run. A bank run happens when many depositors get scared and withdraw their money at the same time.

• The bank holds only a fraction of deposits as cash, so it cannot pay everyone.
• Class 10 asks: "What would happen if all the depositors went to ask for their money at the same time?"
• This is why an economy needs:
  • a lender of last resort: a central bank (the RBI in India) that lends to a sound bank in an emergency;
  • deposit insurance: a promise that small depositors get their money back even if a bank fails.

2. The bank balance sheet

• A bank balance sheet is a statement of what a bank owns (assets) and what it owes (liabilities). Both sides must balance.
• Assets = Reserves + Loans
• Liabilities = Deposits. A deposit is money the bank owes to the depositor.

• Net worth = Assets − Liabilities

• Bank reserves = vault cash (cash in the bank's own safe) + the bank's deposits with the central bank.

• Reserves are kept aside against deposits. They are not lent.

• The Cash Reserve Ratio (CRR) sets the legal minimum.

• Official definition of CRR: the average daily balance a bank must keep with the Reserve Bank, as a per cent of its net demand and time liabilities (NDTL) [2].

• NDTL means, roughly, the bank's total deposits and similar liabilities to the public, after some adjustments.

• Statutory Liquidity Ratio (SLR): a separate rule. Banks must keep a set share of their demand and time liabilities in safe liquid assets, "typically in unencumbered government securities, cash and gold" [2]. ("Unencumbered" means not already pledged as security for another loan.)

• CRR is paid into the RBI, and banks earn nothing on it. SLR money stays with the bank as investments that earn interest.

3. Credit creation: a worked example with one bank (CRR 20%)

• Credit creation: banks lend out deposits, the loans come back into banks as new deposits, and those are lent again. In the end, total deposits (money) become a multiple of the reserves.
• Worked example (CRR = 20%):
• Leela deposits ₹100.
• The bank keeps ₹20 as a reserve and lends ₹80 to Jaspal Kaur. Jaspal spends it, and the ₹80 comes back as a deposit. Deposits are now ₹180.
• Required reserves = 20% of 180 = ₹36. The bank already holds ₹100 in cash, so it can lend ₹64 more (to Junaid).
• This continues until deposits reach ₹500.

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

• Result: M1 (money held by the public) rises from ₹100 to ₹500.
• Why exactly 500? The series: 100 + 80 + 64 + 51.2 + … is a geometric series with ratio r = 0.8.
• Sum = 100 × 1/(1 − 0.8) = 100 × 5 = ₹500.

4. The money multiplier

• Money multiplier (m): the number of rupees of money created for every rupee of reserves.
• Simple formula: m = 1/CRR

• CRR 20%: m = 1/0.2 = 5.

• If CRR is raised to 25%:

• m = 1/0.25 = 4, so maximum deposits = 100 × 4 = ₹400.
• Maximum loans fall from ₹400 to ₹300.
• Banks must call back (recall) loans of ₹100.

• A higher CRR means less credit, which means less money supply.

• Fuller formula (NCERT): m = (1 + cdr)/(cdr + rdr)

• Currency deposit ratio (cdr) = currency held by the public ÷ the public's bank deposits. It shows how much people like to hold cash.
• Reserve deposit ratio (rdr) = the share of deposits that banks keep as reserves (required reserves plus any extra they choose to keep).
• Worked example: cdr = 0.25, rdr = 0.20. Then m = 1.25/0.45 ≈ 2.8.
• Wider banking habit: when people keep more money in banks and less as cash, cdr falls and m rises.

• Special case: if cdr = 0 (nobody holds cash), then m = 1/rdr. This is the simple formula above.

• Present-day CRR:

• CRR was cut to 4.0% of NDTL in December 2024 [5].
• It now stands at 3.00% [3].
• At 3%, the simple formula gives m = 1/0.03 ≈ 33. The actual multiplier is only about 5–6 (see Section 7). The gap exists because the public holds a lot of cash (cdr) and banks keep vault cash above the CRR. So the fuller formula describes India better.

5. NCERT errors to note (Class 12, Money and Banking)

• Where CRR is kept. NCERT defines CRR as reserves kept "with the bank".

• Correct: CRR balances are kept with the RBI [2].

• What counts as reserves. NCERT says reserves include bonds and T-bills "issued by the RBI".

• Correct: reserves = vault cash + deposits with the RBI.
• Government securities count towards SLR, not CRR [2].

• Also, T-bills are issued by the RBI on behalf of the Government. They are government debt, not RBI liabilities.

• The appendix sum. The appendix sums the series with r = 0.4 and gets 5/3.

• This does not match the 20% CRR example.
• Correct: r = 1 − 0.2 = 0.8, so 1/(1 − 0.8) = 5.

6. High-powered money (M0)

• High-powered money is also called reserve money, the monetary base or M0. It is the RBI's total monetary liability, meaning the money the RBI itself has issued and owes.

• It is "high-powered" because it is the base on which banks build credit. Each rupee of H supports several rupees of M3.

• Formula: M0 = currency in circulation + bankers' deposits with RBI + other deposits with RBI

• Currency in circulation = currency with the public + cash with banks.

• Table 3.5 figures (2024-25):

Component	₹ crore
Currency in circulation	37,24,448 (₹37.24 lakh crore)
Bankers' deposits with RBI	9,91,488 (₹9.91 lakh crore)
Other deposits with RBI	1,13,307
M0 (sum)	≈ 48,29,243 (≈ ₹48.3 lakh crore)

• Errors in Table 3.5:
• Cash with banks for 2024-25 is printed as 9396. It should be about ₹93,697 crore (37,24,448 − 36,30,751).

• Currency with the public for 2016-17 is printed as 124124. It should be about ₹12,64,124 crore.

• Sources of M0 (the RBI assets that create reserve money):

• RBI's net credit to government: the RBI buys government securities or lends to the government.
• RBI's credit to banks: for example, repo loans.
• Net foreign exchange assets: when the RBI buys dollars, it pays in rupees.

• Whenever any of these rises, H rises. That allows more credit creation.

• Link to policy rates. The repo rate is the rate at which the RBI lends to banks for a short time. It was cut by 50 basis points to 5.50% on 6 June 2025, at the 55th MPC meeting [2].

• After that cut, the SDF rate became 5.25%, and the MSF rate and the Bank Rate became 5.75% [2].
• The Standing Deposit Facility (SDF) is where banks park extra money with the RBI. The Marginal Standing Facility (MSF) lets a bank borrow overnight from the RBI in an emergency, using up to 2% of NDTL of its SLR holdings as security [2].
• The Bank Rate is published under Section 49 of the RBI Act, 1934. It is also the penal rate charged when a bank falls short of its CRR or SLR [2].

7. Money supply

• Money supply is the total stock of money held by the public at a point in time.
• It is created jointly by the RBI (which supplies H) and the banks (which multiply H through lending).

• It does not include money held by the government or by the banking system itself.

• Formula: Money supply = m × H

• 2024-25: m = M3 ₹272.87 lakh crore ÷ M0 ₹48.3 lakh crore ≈ 5.6.

• Check with the fuller formula (approximate, 2024-25):

• Currency with the public ≈ ₹36.3 lakh crore. Deposits ≈ 272.87 − 36.3 ≈ ₹236.6 lakh crore. So cdr ≈ 0.15.
• Bank reserves = cash with banks ₹0.94 lakh crore + deposits with RBI ₹9.91 lakh crore ≈ ₹10.85 lakh crore. So rdr ≈ 0.046.

• m ≈ 1.15/(0.15 + 0.046) ≈ 5.8. This is close to 5.6. The small gap comes from "other deposits" and differences in definitions.

• Official method. The RBI has compiled monetary statistics since July 1935. It derives M3 using a balance-sheet approach, which combines the balance sheets of the RBI and the banking sector (commercial and co-operative banks) [4].

8. Measures of money (RBI)

Measure	Definition	Type
M1	Currency with the public + net demand deposits of banks + other deposits with RBI	Narrow (most liquid)
M2	M1 + Post Office savings bank deposits	Narrow
M3	M1 + net time deposits of banks	Broad; most used ("aggregate monetary resources")
M4	M3 + total Post Office savings deposits (excluding NSC)	Broad (least liquid)

• Liquidity means how easily money can be spent. It falls from M1 to M4.
• Demand deposits (savings and current accounts) can be withdrawn at any time. Time deposits (fixed deposits) are locked for a period.
• Growth of M3: ₹11.24 lakh crore (1999-2000) → ₹272.87 lakh crore (2024-25). That is about a 24-fold rise in 25 years.
• Committee link: the Working Group on Money Supply: Analytics and Methodology of Compilation was chaired by Dr Y.V. Reddy, then Deputy Governor. It reported in June 1998 [4].
• It proposed new aggregates NM1, NM2, NM3, based on residency and maturity, and liquidity aggregates L1, L2, L3 [4].

• It also proposed regular analytical surveys of the RBI, banks and the wider financial sector [4].

• Full treatment of the measures → money-evolution-functions.

9. Class 12 exam question: "Is a commercial bank a creator of money?"

• Yes. When a bank gives a loan, it creates a deposit, and deposits are money (part of M1 and M3).
• But only within limits:
• High-powered money (H): banks cannot create H. Only the RBI can.
• CRR: a higher CRR means a smaller multiplier.
• The public's cash habit (cdr): more cash held outside banks means less money comes back to be lent again.
• Demand for loans: banks cannot lend if firms and households do not want to borrow.

Prelims Hooks

• High-powered money = M0 = reserve money = monetary base = currency in circulation + bankers' deposits with RBI + other deposits with RBI.
• Simple multiplier = 1/CRR. Fuller multiplier m = (1 + cdr)/(cdr + rdr). If cdr falls, m rises.
• Money supply = m × H. In India (2024-25), m ≈ 5.6 (M3 ₹272.87 lakh crore ÷ M0 ₹48.3 lakh crore).
• CRR is kept with the RBI, as a % of NDTL, and earns no interest. SLR is kept by the bank itself in G-secs, cash and gold [2]. A classic trap: "CRR balances can be held in government securities". This is false.
• M3 = M1 + net time deposits of banks = "aggregate monetary resources". M1 and M2 are narrow money. M3 and M4 are broad money.
• "Other deposits with RBI" appear in both M0 and M1. Post Office deposits appear in M2 and M4, not in M1 or M3.
• Sources of M0: RBI's net credit to government + RBI's credit to banks + net foreign exchange assets. So when the RBI buys forex, reserve money rises.
• The Bank Rate is published under Section 49, RBI Act 1934 [2]. The repo rate was 5.50% after 6 June 2025 [2]. CRR is 3.00% [3].
• The Y.V. Reddy Working Group (June 1998) proposed NM1–NM3 and L1–L3 [4].
• A bank run is the risk built into fractional-reserve banking. The answer to it is a lender of last resort + deposit insurance.

Mains Points

• The RBI controls money supply only partly.
• The RBI controls H and the CRR.
• The multiplier also depends on how much cash the public holds (cdr) and on how much banks want to lend and borrowers want to borrow.
• So cutting CRR (4% in Dec 2024 [5] → 3% [3]) releases money to banks, but credit grows only if there is demand for loans.

• This explains why rate or CRR cuts can pass through weakly to the economy. (GS-III: monetary policy effectiveness.)

• Financial inclusion makes monetary policy stronger.

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

• Demonetisation (2016-17) showed the reverse: currency with the public fell sharply (see Table 3.5, 2016-17).

• Sources of reserve money connect fiscal, external and monetary policy.

• Large RBI purchases of G-secs (net credit to government) or forex purchases (to stop the rupee from rising) expand H automatically.

• The RBI may then have to sterilise: absorb that extra money through OMO sales, MSS bonds or the SDF, so inflation does not rise.

• The trade-off of fractional reserves.

• Low reserves allow more lending and growth.
• But they raise the risk of a bank run.
• So credit creation must come with prudential rules (CRR, SLR, capital norms), a lender of last resort and deposit insurance (DICGC). This point suits GS-III answers on financial stability and banking reform.