When a bank grants loan to a person, it does not give it in cash to the borrower rather loan is credited in the borrower’s account. Every bank loan, thus, creates an equivalent deposits with the bank. The bank on the basis of legal reserve ratio is required to maintain a specified percentage of its deposits as cash reserve. Legal reserve ratio (a mix of Cash Reserve Ratio and Statutory Liquidity Ratio) is determined by the central bank of the country. If legal reserve ratio is increased, the capacity of bank to create credit is reduced.
Thus, the capacity of commercial banks to create credit depends on following two factors :
• Amount of deposit
• Legal reserve ratio.
Given the amount of fresh deposits and legal reserve ratio, the total money creation will be as under :
Total money creation = Initial Deposit x \(\frac{1}{legal\,Reserve\,Ratio}\)
Let us take an example. Suppose a bank gets a deposit of ₹40,000. Legal Reserve ratio is 20%. It means that bank can lend 80% of ₹ 40,000 i.e., ₹ 32,000. Borrowers are not given loan in cash and loan is credited to their account. Again 80% of ₹32,000 may be advanced as a loan to other borrowers. This process goes on and on. As a result, the bank creates credit a number of times (5 times) of primary deposits i.e., ₹2,00,000.
Total money creation = 40,000 x \(\frac{1}{0.20}\)
=₹ 2,00,000.