Credit creation is the process by commercial banks to increase the money supply of a country or monetary region. In most modern economics, most of the money supply is in the form of bank deposits. So credit creation is also known as ‘Deposit Creation.’

Commercial banks create credit by advancing loans and purchasing securities. Banks use public deposits to lend money to businesses or individuals. It doesn’t mean they simply lend the money which they deposit. Banks use a method which is called fractional reserve banking. Where they use a portion of the deposit to provide loans with high interest rates.

Basic concepts of credit creation:-

1. Cash Reserve Ratio (CRR):- CRR is the percentage of total deposits that the banks must hold in cash reserve to meet the deposits’ demand for cash.
2. Credit multiplier: A bank can create multiple times credit. For a certain amount, a bank can lend to many individuals or businesses. And this business lends to someone again. This circular process is never-ending. It generates more and more money.
3. Legal Reserve Ration (LRR):- The minimum ration of deposit legally required to be kept as cash or in liquid form by the banks.

Now let’s understand the process by the Example:–

Assume, A person deposits Rs.10,000 in Bank ‘A’. As required the banks keep LRR 20% of the deposit of Rs. 2000 and Then Bank ‘A’ lends the remaining amount to Bank ‘B’ (10,000-2,000 = Rs.8,000)

Again, Bank ‘B’ keeps LRR 20% of Rs.8,000 means Rs.1,600 then lends the remaining amount to any business. (8,000- – 1,600 = Rs.6,400)

The money goes on multiplying in this way this process continues till new deposits become nil.

Ultimately, Total money creation = INITIAL DEPOSIT * 1/LRR%

                                                               10,000 * 1/20% = Rs. 50,000