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Explain the process of credit creation.
The process of credit creation is primarily done by the commercial banks as it is one of the most important processes that facilitate the economic growth of a nation. Credit creation refers to the practice in which banks lend money to the borrowers out of their deposits after keeping aside a part ofRead more
The process of credit creation is primarily done by the commercial banks as it is one of the most important processes that facilitate the economic growth of a nation. Credit creation refers to the practice in which banks lend money to the borrowers out of their deposits after keeping aside a part of it as Legal Reserve Ratio (LRR).
The process of credit creation mainly involves the following steps:
1. A customer deposits his savings with the bank as a savings account or deposit (RD or FD).
2. The bank keeps aside a part of it in a prescribed ratio (i.e. LRR), which is determined by the Central Bank (RBI).
3. The bank, then, lends the remaining money as loan to a third person at a predetermined rate of interest and mutually agreed terms and conditions.
4. The borrower deposits that money into his/her account in some other bank which becomes a deposit for that bank and this process continues again.
This process keeps on moving which ultimately leads to circular flow of money as deposits and loans in banking sector. In this way, the process of credit creation is done by the commercial banks in a country.
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