Notes on Commercial Banks and Credit Creation

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The stability of price level is an essential condition for the economic development. It highly depends upon the demand and supply of money. The supply of money includes the legal tender money and bank money.

The legal tender money is issued by the Central Bank or the government of the country in the form of Bank/Currency notes while the bank money is created by the banks.

The bank money consists of bank deposits. Cheques drawn on bank deposits act as the legal tender money, i.e., with cheques payment obligation can be settled. Thus, banks are not merely purveyors of money but also the manufacturers of money.

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Bank deposits may be arrived in the following two ways:

1. Primary deposit and

2. Derivative deposits.

1. Primary Deposits

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It is also known as cash deposit or passive deposit. When customers take actual cash and deposit it with bank, it is known as the primary deposit.

2. Derivative Deposits

It is also called active deposits or creative deposits. Deposits also arise when customĀ­ers are granted accommodation in the form of loans. These deposits add to the supply of money.

When a bank grants a loan to a customer it does not usually pay the amount in cash, instead it credits an account with the amount of loan. That is, the bank places a deposit at the borrower’s disposal and he can freely withdraw the amount as he likes.

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He can draw cheques against the deposits created in his favour for settling his transactions. Thus, cheques against bank deposits become purchasing power in the hands of the public in addition to the legal tender money. But more often, the loan is utilized over a long time gradually and till such time it forms as deposit.

Hence, the loan which a banker grants to a customer usually large corporate creates additional deposits, i.e., by advancing loans, banks create deposits and thus, create money. So “Money is said to be created when the banks, through their lending activities, make a net addition to the total supply of money in the economy”.

The customer may retain the loan amount with the bank as deposits or can issue cheques against this deposit to settle his dues. The receiver of the cheque may deposit it in the same bank in which case his deposits increase while the givers deposit decreases. In case the borrower has account in some other bank the deposit of that bank increases.

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