Commercial banks are able to multiply creation of credit, when deposits are made with them. If cash is removed from the banking system, it results in multiple contraction of credit.
Let us trace withdrawal of cash with the help of the following example. The “Bank B” has a cash reserve of 10,000 at 20% of total deposits of Rs. 50,000 and Rs. 40,000 as investments. Now the position of the bank will be as follows:
Cash and Balances with RBI Investments From the balance sheet, it could be seen that the cash reserve is below the legal minimum and it should be Rs. 9000, i.e., 20% of Rs. 45,000. Therefore the bank must sell Rs. 4,000 worth of investments.
When the bank sells its securities there will be a chain of reaction. The buyer of the security may withdraw Rs. 4,000 from his bank say Vijaya Bank to pay for it. Then the Vijaya Bank will find its cash reserves fallen by Rs. 4,000. It will therefore sell some of its securities.
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And so it goes on until all the effects are exhausted. And the original withdrawal of Rs. 5,000 has produced a chain “Killing off” Rs. 25,000 worth of deposits throughout the whole banking system. The process of contraction of bank deposits is the same as that of credit expansion but in the opposite direction.