(a) Yes, commercial bank acts as a ‘Creator of money’ in the economy. It can be explained with the help of Credit creation process:
1. Let us assume that the entire commercial banking system is one unit. Let us call this one unit simply “banks’. Let us also assume that all receipts and payments in the economy are routed through the banks. One who makes payment does it by writing cheque. The one who receives payment deposits the same in his deposit account.
2. Suppose initially people deposit Rs 1000. The banks use this money for giving loans. But the banks cannot use the whole of deposit for this purpose. It is legally compulsory for the banks to keep a certain minimum fraction of these deposits as cash. The fraction is called the Legal Reserve Ratio (LRR). The LRR is fixed by the Central Bank.
3. Let us now explain the process, suppose the initial deposits in banks is Rs 1000 and the LRR is 10 percent. Further, suppose that banks keep only the minimum required, i.e., Rs 100 as cash reserve, banks are now free to lend the remainder Rs 900. Suppose they lend Rs 900. What banks do to open deposit accounts in the names of the borrowers who are free to withdraw the amount whenever they like. Suppose they withdraw the whole of amount for making payments.
4. Now, since all the transactions are routed through the banks, the money spent by the borrowers comes back into the banks into the deposit accounts of those who have received this payment. This increases demand deposit in banks by Rs 900. It is 90 per cent of the initial deposit. These deposits of Rs 900 have resulted on account of loans given by the banks. In this sense the banks are responsible for money creation. With this round increase in total deposits is now Rs 1900 (=1000 + 900).
5. When banks receive new deposit of ?900, they keep 10 per cent of it as cash reserves and use the remaining Rs 810 for giving loans. The borrowers use these loans for making payments. The money comes back into the accounts of those who have received the payments. Bank deposits again rise, but by a smaller amount of Rs 810. It is 90 per cent of the last deposit creation. The total deposits now increase to Rs 2710 (=1000 + 900 + 810). The process does not end and continues till total deposit creation comes to Rs10000, ten times the initial deposit as shown in the table below.
(b)
- The investment multiplier refers to the stimulative effects of public or private investments.
- It is rooted in the economic theories of John Maynard Keynes.
- The extent of the investment multiplier depends on two factors: the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).
- A higher investment multiplier suggests that the investment will have a larger stimulative effect on the economy.
