Explain the process of credit creation by commercial bank?
Thursday, March 02, 2023
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Question: Explain the process of credit creation by commercial bank?
Commercial banks are key players in the process of credit creation in an economy. When a bank receives a deposit, it is required to hold a portion of it as reserves, while the remaining amount can be used for lending. The bank creates credit by issuing loans to borrowers, and the amount of credit created is determined by the reserve requirement set by the central bank. For example, if the reserve requirement is set at 10%, a bank can lend up to 90% of the deposit it received. As the borrower spends the loan amount, the money enters the economy, and a portion of it may be deposited back into the bank. The bank can then use this deposit to make new loans, thereby creating more credit. This process of credit creation continues, leading to a multiplier effect on the initial deposit. However, commercial banks must ensure that they maintain adequate reserves to meet their obligations, and the central bank can influence the amount of credit created by adjusting reserve requirements and interest rates. Understanding the process of credit creation by commercial banks is essential in analyzing the role of banks in promoting economic growth and stability.
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