Saturday, March 7, 2009

How Credit is Created

Now suppose, a person deposits $1000 with a bank, ten percent of which will go to the central bank as such reserve requirement. Hence the commercial bank is left with $900 to be used for advancing loans. The party ‘A’ that borrows this $900 will either buy goods from or make payment to the other party B. The party B will receive the cheque for $900 and deposit it its account with the same commercial bank. Now the bank receives the deposit of $900. Ten percent of this amount ($90) will as usual go to the central bank and the rest of the amount ($810) will be utilized in advancing loans. At this stage the bank has net deposit of $1710 ($900+ $810), though the original deposit is $1000. In this fashion the credit money will go on increasing at every transaction. If the original deposit is $1000 the extent of credit expansion will be $10,000.

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