The deposits are raised in the following manner. When a customer goes to his bank for a loan, generally he provides “collateral security”. The banker grants a loan and credit to his account with the amount of the loan.
The customer is entitled to draw cheques up to the amount of the loan and this cheque can be used to buy goods and to discharge business obligations. In this way additional money comes into existence and the process is virtually equivalent to the creation of additional supplies of money.
It should be noted that primary deposits do not create credit and they go to increase the cash reserve of the bank as actual cash is paid into the bank.
But the derived deposits decrease the cash ratio of the bank because that are created without, receiving any cash from the customers. Thus, when a loan is granted to a customer a deposit arises.
We can explain the technique of credit creation with the help of the following examples:
Let us assume;
(i) There are number of banks exist and operating in the economy.
(ii) The banks have to keep 10% of the deposits as cash reserves as per law.
(iii) The customer Mr. X deposits the amount of Rs. 10,000 into his bank say ABC Bank.
From the above discussion that banks create deposits by granting loans to customers. When a loan is granted and a deposit is created, the liabilities side of the balance sheet of the bank “increases under the heading deposits” while the corresponding increase can be found on the assets side of the balance sheet under the head “advances”.
Banks voluntarily acquire liabilities when they create deposits because they are able to earn more profit on the loans they grant. This process of creation of deposit is essentially an exchange of claims.
Because of this capacity to manufacture money, banks are very important institutions for the economy of a country. They create additional purchasing power and there by influence the price level.