Money/credit creation is an important function of the commercial banks. By creating credit, commercial banks contribute to money supply in the economy. They create credit in the form of demand deposits. Demand deposits of the commercial banks are many times more than their cash reserves. If cash reserves are (say) Rs. 1,000 and if the demand deposits are (say) RS. 10,000, then the commercial banks are creating credit ten times of their cash reserves. Accordingly, on the basis of cash reserves of Rs. 1,000, the commercial banks are contributing Rs. 10,000 to the supply of money. The process of credit creation is like this: Initially, bank receives deposits of Rs. 1,000. The required reserves to tackle the liability of Rs. 1,000 is equal to Rs. 100 (on the assumption that cash reserve ratio is 10% of total deposits). Implying that the banks have excess reserves = Rs. 1,000 – Rs. 100 = Rs. 900 which they can use for the purpose of lending. When these excess reserves are loaned out, total deposits of the bank amount to Rs. 1000 + Rs. 900 = Rs. 1,900. The banks need to hold cash reserves as 10% of Rs. 1,900 or Rs. 190, while their actual reserves are Rs. 1,000. Implying excess reserves of Rs. 1,000 – Rs. 190 = Rs. 810 can be loaned. This process continues till total demand deposits are Rs. 10,000 and cash reserves are Rs. 1,000. Thus, if required reserve ratio is equal to 10%, total cash reserves of Rs.1,000 allow the bank to create demand deposits upto Rs. 10,000. So that,
Demand Deposits = 1/RP x Cash Reserves = 1/10% x 10000 = 10000
Here, RR refers to reserve requirement of the commercial banks as a percentage of their demand deposits. Here, it is important to note that loans are never offered in cash. These are always reflected as demand deposits in favour of the borrowers. Accordingly, when loans are offered, demand deposits of the banks lend to build up. In the above example, cash reserves of Rs. 1,000 allow demand deposits of Rs.10,000 which serve as a source of money supply.