Definition:

Money creation is the process by which new money is produced or issued.

There are three ways to create money: “by manufacturing paper currency or
metal coins, through fractional reserve banking and lending by the banking
system “and by government policies such as quantitative easing.

Meaning:

Credit creation is most important function of commercial bank, like other

financial institute bank aim to earn profit by make advance to other.
Therefore, some time bank is called a factory of credit creation. Everyone
know that people cannot withdraw money in simultaneous, some with drawl
while other deposit at same time. So bank encourage credit creation by given
advance to other, keep small cash in reserve se for day to day transaction.

Credit creation is the multiple expansions of banks demand deposits. It is an

open secret now that banks advance a major portion of their deposits to the
borrowers and keep smaller parts of deposits to the customers on demand.
Even then the customers of the banks have full confidence that the depositor's
lying in the banks is quite safe and can be withdrawn on demand. The banks
exploit this trust of their clients and expand loans by much more time than the
amount of demand deposits possessed by them. The single bank cannot create
credit. It is the banking system as a whole which can expand loans by many
times of its excess cash reserves. Further, when a loan is advanced to an
individuals or a business concern, it is not given in cash. The bank opens a
deposit account in the name of the borrower and allows him to draw upon the
bank as and when required. The loan advanced becomes the gain of deposit by
some other bank. Loans thus make deposits and deposits make loans.

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In economics, money creation is the process by which the money supply of a
country is expanded. There are two principal stages of money creation. First,
the central bank of a country can introduce or issue new money into the
economy (termed 'expansionary monetary policy'). A central bank usually
injects new money into the economy by purchasing financial assets. Second,
the new money introduced by the central bank is multiplied by commercial
banks through fractional reserve banking, expanding the amount of broad
money (i.e. cash plus demand deposits) in the economy.

Central banks monitor the amount of money in the economy by measuring

monetary aggregates such as M2. The effect of monetary policy on the money
supply is indicated by comparing these measurements on various dates. For
example in the US, M2 grew from $6407.3bn in January 2005 to $8318.9bn in
January 2009.

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The Art of Money Creation:
Banks create money out of thin air. It is a by-product of their quest for profit.
The entire economy thrives (and occasionally, falls too) on this ability of
‘credit creation‘by ‘money factories‘. How do banks create more money than
actually exists? How does this enable an increase in total volume of money in
the economy? What are the risks?

First, let’s get on the same page with some basics:

 Banks get money from what we deposit in them.

 Deposits are banks’ liabilities, since banks must return it to us when we
ask for the money.
 Banks lend loans by using this deposit money of ours.
 Loans are bank’s assets.

The CRR:

Reserve Bank of India (RBI) is the central note issuing authority in India.
Commercial Banks in India are required to hold a certain proportion of their
deposits in the form of cash. This minimum ratio (that is the part of the total
deposits to be held as cash) is stipulated by the RBI and is known as the CRR
or Cash Reserve Ratio. It is a tool used by RBI to control liquidity in the
banking system.

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The Process:

Let’s assume there are various Banks in the Banking System. Bank_1, Bank_2,
Bank_3, etc. Let’s assume the CRR to be 10%.

1. Anand deposits Rs. 100 in Bank_1. Keeping Rs. 10 in reserve (CRR is

10%), Bank_1 lends Rs. 90 to Bala.
2. Bala deposits his Rs. 90 in Bank_2. Keeping Rs. 9 in reserve, Bank_2
lends Rs. 81 to Clara.
3. Clara deposits her Rs. 81 in Bank_3.

This process continues.

The Math Behind This:

Time for some calculations. In the first cycle, the bank could loan out 90% of
Rs. 100. In the second cycle, the bank could loan out 90% of 90% of Rs. 100.
Thus the amount of money the bank can loan out in some period n of the cycle
is given by:

Rs. 100 * (90%) n

 Let A be the amount of money infused into the system (in our case, Rs.
100)
 Let R be the required reserve ratio (in our case 10%).
 Let T be the total amount the bank loans out
 Let n represent the period we are in.

From the equation above, the amount of money the bank can loan out in any
period is:

A * (1 – R) n

Thus, the total loan amount is:

T = A*(1 – R)1 + A*(1 – R)2 + A*(1 – R)3 + …

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T = A * [ (1 - R) 1 + (1 - R )2 + (1 - R)3 + ... ]

Mathematics says,

x1 + x2 + x3 + x4 + … = x / (1-x)

Thus,

T = A * (1 – R) / R

How much money have our banks loaned out using the Rs. 100 deposited
initially? Using the above equation, this would total up to 100 * (1 – 0.1)/0.1 =
Rs. 900.

In this entire process, to find the total amount deposited (D), we need to take
into account the initial Rs. 100 too.

D  = A + T

D = A + [A * (1 - R) / R ]

D = A * (1/R)

Which, for our example, will total to Rs. 1000.

The cash in reserve for any period is:

R * A * (1 – R)n-1

Total reserve is:

( R * A ) [1 + (1 - R)1 + (1 - R)2 + (1 - R)3 ... ]

Which simplifies to A = Rs. 100

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The Balance Sheet:
This is how the combined balance sheet of the Banks will look like:

Bank Liabilities  Assets Reserve Total Assets

Deposits Credits
Bank_1 100 90 10 100
Bank_2 90 81 9 90
Bank_3 81 72.9 8.1 81
- - - - -
- - - - -
Bank_n 00 00 00 00
Total 1,000 900 100 1000

Such is the power of this simple process that banks have created an asset of
Rs. 1000 using an initial money of Rs. 100. In other words, Banks have created
money. This type of banking is called “Fractional Reserve Banking”

Why does this process succeed?

This process succeeds because most money transfers today do not involve
cash or currency. It involves just cheques, DD, etc. or electronic transfer –
mere numbers on a computer screen.

When would it fail?

This system fails in two main cases:

1) Cascade of withdrawals

When all depositors come asking for their money back at the same time. The
banking system will not have enough currency to meet the demands. In fact,
one main purpose of the CRR is that the banks must be able to repay deposits
when there are significantly large numbers of withdrawals.

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 2) Loan defaults

What would happen when the debtors default or fail to repay the loans? This
would also result in banks having insufficient money to pay back depositors.

The financial system is much more complicated than what we have discussed.
But the above two are one of the basic reasons for the recent recession – just
that it involved a cascade of selling stocks on the market, and defaults of
subprime mortgage loans.

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Money creation by the central bank

The conduct and effects of monetary policy and the regulation of the banking
system are of central concern to monetary economics.

Within almost all modern nations, special institutions (such as the Federal
Reserve System in the United States, the Bank of England, the European
Central Bank, the People's Bank of China, and the Bank of Japan) exist which
have the task of executing the monetary policy and often acting independently
of the executive. In general, these institutions are called central banks and
often have other responsibilities such as supervising the smooth operation of
the financial system. There are several monetary policy tools available to a
central bank to expand the money supply of a country: decreasing interest
rates by fiat; increasing the monetary base; and decreasing reserve
requirements. All have the effect of expanding the money supply.

The primary tool of monetary policy is open market operations. This entails
managing the quantity of money in circulation through the buying and selling
of various financial assets, such as treasury bills, government bonds, or
foreign currencies. Purchases of these assets result in currency entering
market circulation (while sales of these assets remove money from
circulation).

Usually, the short term goal of open market operations is to achieve a specific
short term interest rate target. In other instances, monetary policy might
instead entail the targeting of a specific exchange rate relative to some foreign
currency, the price of gold, or indices such as Consumer Price Index. For
example, in the case of the USA the Federal Reserve targets the federal funds
rate, the rate at which member banks lend to one another overnight. The
other primary means of conducting monetary policy include: (i) Discount
window lending (as lender of last resort); (ii) Fractional deposit lending
(changes in the reserve requirement); (iii) Moral suasion (cajoling certain
market players to achieve specified outcomes); (iv) "Open mouth operations"
(talking monetary policy with the market).

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Quantitative Easing:

Quantitative easing involves the creation of a significant amount of new base

money by a central bank by the buying of assets that it usually does not buy.
Usually, a central bank will conduct open market operations by buying short-
term government bonds or foreign currency. However, during a financial
crisis, the central bank may buy other types of financial assets as well. The
central bank may buy long-term government bonds, company bonds, asset
backed securities, stocks, or even extend commercial loans. The intent is to
stimulate the economy by increasing liquidity and promoting bank lending,
even when interest rates cannot be pushed any lower.

Quantitative easing increases reserves in the banking system (i.e. deposits of

commercial banks at the central bank), giving depository institutions the
ability to make new loans. Quantitative easing is usually used when lowering
the discount rate is no longer effective because they are already close to or at
zero. In such a case, normal monetary policy cannot further lower interest
rates, and the economy is in a liquidity trap.

Physical Currency:

In modern economies, relatively little of the money supply is in physical

currency, in the U.S., only about 2% to 3% of the total money supply consists
of physical coins and paper money. The manufacturing of new physical money
is usually the responsibility of the central bank, or sometimes, the
government's treasury.

Contrary to popular belief, money creation in a modern economy does not

directly involve the manufacturing of new physical money, such as paper
currency or metal coins. Instead, when the central bank expands the money
supply through open market. Commercial banks may draw on these accounts
to withdraw physical money from the central bank. Commercial banks may
also return soiled or spoiled currency to the central bank in exchange for new
currency.

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Money creation through the fractional reserve system

Through fractional-reserve banking, the modern banking system expands the

money supply of a country beyond the amount initially created by commercial
banks. There are two types of money in a fractional-reserve banking system,
currency originally issued by the central bank, and bank deposits at
commercial banks:

1. Central bank money (all money created by the central bank regardless
of its form (banknotes, coins, electronic money through loans to private
banks))
2. Commercial bank money (money created in the banking system
through borrowing and lending) - sometimes referred to as checkbook
money

When a commercial bank loan is extended, new commercial bank money is

created. As a loan is paid back, the commercial bank money disappears from
existence. Since loans are continually being issued in a normally functioning
economy, the amount of broad money in the economy remains relatively
stable. Because of this money creation process by the commercial banks, the
money supply of a country is usually a multiple larger than the money issued
by the central bank; that multiple is primarily determined by the reserve ratio
set by the relevant banking regulators in the jurisdiction.

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Fractional Reserve Banking:

Fractional-reserve banking is the banking practice in which only a fraction

of a bank's demand deposits are kept as reserves (cash and other highly liquid
assets) available for withdrawal. The bank lends out some or most of the
deposited funds, while still allowing all deposits to be withdrawn upon
demand. Fractional reserve banking is practiced by all modern commercial
banks.

The practice of fractional reserve banking expands the money supply (cash
and demand deposits) beyond what it would otherwise be. Due to the
prevalence of fractional reserve banking, the broad money supply of most
countries is a multiple larger than the amount of base money created by the
country's central bank. That multiple (called the money multiplier) is
determined by the reserve requirement or other financial ratio requirements
imposed by financial regulators, and by the excess reserves kept by
commercial banks.

Central banks generally mandate reserve requirements that require banks to

keep a minimum fraction of their demand deposits as cash reserves. This both
limits the amount of money creation that occurs in the commercial banking
system,[6] and ensures that banks have enough ready cash to meet normal
demand for withdrawals. Problems can arise, however, when depositors seek
withdrawal of a large proportion of deposits at the same time; this can cause a
bank run or, when problems are extreme and widespread, a systemic crisis.
To mitigate these problems, central banks (or other government institutions)
generally regulate and oversee commercial banks, act as lender of last resort
to commercial banks, and also insure the deposits of the commercial banks'
customers.

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How it works:

The nature of modern banking is such that the cash reserves at the bank
available to repay demand deposits need only be a fraction of the demand
deposits owed to depositors. In most legal systems, a demand deposit at a
bank (e.g. a checking or savings account) is considered a loan to the bank
(instead of a bailment) repayable on demand that the bank can use to finance
its investments in loans and interest bearing securities. Banks make a profit
based on the difference between the interest they charge on the loans they
make, and the interest they pay to their depositors. Since a bank lends out
most of the money deposited, keeping only a fraction of the total as reserves, it
necessarily has less money than the account balances of its depositors.

The main reason customers deposit funds at a bank is to store savings in the
form of a demand claim on the bank. Depositors still have a claim to full
repayment of their funds on demand even though most of the funds have
already been invested by the bank in interest bearing loans and securities.
Holders of demand deposits can withdraw all of their deposits at any time. If
all the depositors of a bank did so at the same time a bank run would occur,
and the bank would likely collapse. Due to the practice of central banking, this
is a rare event today, as central banks usually guarantee the deposits at
commercial banks, and act as lender of last resort when there is a run on a
bank. However, there have been some recent bank runs: the Northern Rock
crisis of 2007 in the United Kingdom is an example. The collapse of
Washington Mutual bank in September 2008, the largest bank failure in
history, was preceded by a "silent run" on the bank, where depositors
removed vast sums of money from the bank through electronic transfer.
However, in these cases, the banks proved to have been insolvent at the time
of the run. Thus, these bank runs merely precipitated failures that were
inevitable in any case.

In the absence of crises that trigger bank runs, fractional-reserve banking

usually functions smoothly because at any one time relatively few depositors
will make cash withdrawals simultaneously compared to the total amount on
deposit, and a cash reserve can be maintained as a buffer to deal with the
normal cash demands from depositors seeking withdrawals. In addition, in a
normal economic environment, cash is steadily being introduced into the
economy by the central bank, and new funds are steadily being deposited into
the commercial banks.

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However, if a bank is experiencing a financial crisis, and net redemption
demands are unusually large over a period of time, the bank will run low on
cash reserves and will be forced to raise additional funds to avoid running out
of reserves and defaulting on its obligations. A bank can raise funds from
additional borrowings (e.g. by borrowing from the money market or using
lines of credit held with other banks), or by selling assets, or by calling in
short-term loans. If creditors are afraid that the bank is running out of cash or
is insolvent, they have an incentive to redeem their deposits as soon as
possible before other depositors access the remaining cash reserves before
they do, triggering a cascading crisis that can result in a full-scale bank run.

Money Creation:

Modern central banking allows multiple banks to practice fractional reserve

banking with inter-bank business transactions without risking bankruptcy.
The process of fractional-reserve banking has a cumulative effect of money
creation by banks, essentially expanding the money supply of the economy.

There are two types of money in a fractional-reserve banking system

operating with a central bank:

1. central bank money (money created or adopted by the central bank

regardless of its form (precious metals, commodity certificates,
banknotes, coins, electronic money loaned to commercial banks, or
anything else the central bank chooses as its form of money)
2. commercial bank money (demand deposits in the commercial banking
system) - sometimes referred to as chequebook money

When a deposit of central bank money is made at a commercial bank, the

central bank money is removed from circulation and added to the commercial
banks' reserves (it is no longer counted as part of m1 money supply).
Simultaneously, an equal amount of new commercial bank money is created in
the form of bank deposits. When a loan is made by the commercial bank
(which keeps only a fraction of the central bank money as reserves), using the
central bank money from the commercial bank's reserves, the m1 money

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supply expands by the size of the loan. [6] This process is called deposit
multiplication.

Example of deposit multiplication:

The table below displays how loans are funded and how the money supply is
affected. It also shows how central bank money is used to create commercial
bank money from an initial deposit of $100 of central bank money. In the
example, the initial deposit is lent out 10 times with a fractional-reserve rate
of 20% to ultimately create $400 of commercial bank money. Each successive
bank involved in this process creates new commercial bank money on a
diminishing portion of the original deposit of central bank money. This is
because banks only lend out a portion of the central bank money deposited, in
order to fulfill reserve requirements and to ensure that they always have
enough reserves on hand to meet normal transaction demands.

The process begins when an initial $100 deposit of central bank money is
made into Bank A. Bank A takes 20 percent of it, or $20, and sets it aside as
reserves, and then loans out the remaining 80 percent, or $80. At this point,
the money supply actually totals $180, not $100, because the bank has loaned
out $80 of the central bank money, kept $20 of central bank money in reserve
(not part of the money supply), and substituted a newly created $100 IOU
claim for the depositor that acts equivalently to and can be implicitly redeemed
for central bank money (the depositor can transfer it to another account, write
a check on it, demand his cash back, etc.). These claims by depositors on banks
are termed demand deposits or commercial bank money and are simply
recorded in a bank's accounts as a liability (specifically, an IOU to the
depositor). From a depositor's perspective, commercial money is equivalent
to central bank money – it is impossible to tell the two forms of money apart
unless a bank run occurs (at which time everyone wants central bank money).

At this point, Bank A now only has $20 of central bank money on its books.
The loan recipient is holding $80 in central bank money, but he soon spends
the $80. The receiver of that $80 then deposits it into Bank B. Bank B is now in

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the same situation as Bank A started with, except it has a deposit of $80 of
central bank money instead of $100. Similar to Bank A, Bank B sets aside 20
percent of that $80, or $16, as reserves and lends out the remaining $64,
increasing money supply by $64. As the process continues, more commercial
bank money is created. To simplify the table, a different bank is used for each
deposit. In the real world, the money a bank lends may end up in the same
bank so that it then has more money to lend out.

Individual Bank Amount Deposited Lent Out Reserves

A 100 80 20
B 80 64 16
C 64 51.20 12.80
D 51.20 40.96 10.24
E 40.96 32.77 8.19
F 32.77 26.21 6.55
G 26.21 20.97 5.24
I 20.97 16.78 4.19
J 16.78 13.42 3.36
K 13.42 10.74 2.68
10.74
Total Reserves:
89.26
Total Amount of Total Amount Lent Total Reserves +
Deposits: Out: Last amount
Deposited:
457.05 357.05 100

Although no new money was physically created in addition to the initial $100
deposit, new commercial bank money is created through loans. The 2 boxes
marked in red show the location of the original $100 deposit throughout the
entire process. The total reserves plus the last deposit (or last loan, whichever
is last) will always equal the original amount, which in this case is $100. As
this process continues, more commercial bank money is created. The amounts

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in each step decrease towards a limit. If a graph is made showing the
accumulation of deposits, one can see that the graph is curved and approaches
a limit. This limit is the maximum amount of money that can be created with a
given reserve rate. When the reserve rate is 20%, as in the example above, the
maximum amount of total deposits that can be created is $500 and the
maximum increase in the money supply is $400.

For an individual bank, the deposit is considered a liability whereas the loan it
gives out and the reserves are considered assets. Deposits will always be equal
to loans plus a bank's reserves, since loans and reserves are created from
deposits. This is the basis for a bank's balance sheet.

Fractional reserve banking allows the money supply to expand or contract.

Generally the expansion or contraction of the money supply is dictated by the
balance between the rate of new loans being created and the rate of existing
loans being repaid or defaulted on. The balance between these two rates can
be influenced to some degree by actions of the central bank.

This table gives an outline of the makeup of money supplies worldwide. Most
of the money in any given money supply consists of commercial bank money.
[13]
The value of commercial bank money is based on the fact that it can be
exchanged freely at a bank for central bank money.

The actual increase in the money supply through this process may be lower,
as (at each step) banks may choose to hold reserves in excess of the statutory
minimum, borrowers may let some funds sit idle, and some members of the
public may choose to hold cash, and there also may be delays or frictions in
the lending process. Government regulations may also be used to limit the
money creation process by preventing banks from giving out loans even
though the reserve requirements have been fulfilled.

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The expansion of $100 of central bank money through fractional-reserve lending
with a 20% reserve rate. $400 of commercial bank money is created virtually
through loans.

Re-lending:

An early table, featuring reinvestment from one period to the next and a
geometric series, is found in the tableau économique of the Physiocrats, which
is credited as the "first precise formulation" of such interdependent systems
and the origin of multiplier theory.

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Money multiplier:

The most common mechanism used to measure this increase in the money
supply is typically called the money multiplier. It calculates the maximum
amount of money that an initial deposit can be expanded to with a given
reserve ratio – such a factor is called a multiplier. As a formula, if the reserve
ratio is R, then the money multiplier m is the reciprocal, m = 1 / R, and is the
maximum amount of money commercial banks can legally create for a given
quantity of reserves.

In the re-lending model, this is alternatively calculated as a geometric series

under repeated lending of a geometrically decreasing quantity of money:
reserves lead loans. In endogenous money models, loans lead reserves, and it
is not interpreted as a geometric series.

The money multiplier is of fundamental importance in monetary policy: if

banks lend out close to the maximum allowed, then the broad money supply is
approximately central bank money times the multiplier, and central banks
may finely control broad money supply by controlling central bank money, the
money multiplier linking these quantities; this was the case in the United
States from 1959 through September 2008.

If, conversely, banks accumulate excess reserves, as occurred in such financial

crises as the Great Depression and the Financial crisis of 2007–2010 – in the
United States since October 2008, then this equality breaks down, and central
bank money creation may not result in commercial bank money creation,
instead remaining as unlent (excess) reserves. However, the central bank may
shrink commercial bank money by shrinking central bank money, since
reserves are required – thus fractional-reserve money creation is likened to a
string, since the central bank can always pull money out by restricting central
bank money, hence reserves, but cannot always push money out by expanding
central bank money, since this may result in excess reserves, a situation
referred to as "pushing on a string".

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Central Banks:

Government controls and bank regulations related to fractional-reserve

banking have generally been used to impose restrictive requirements on note
issue and deposit taking on the one hand, and to provide relief from
bankruptcy and creditor claims, and/or protect creditors with government
funds, when banks defaulted on the other hand. Such measures have included:

1. Minimum required reserve ratios (RRRs)

2. Minimum capital ratios
3. Government bond deposit requirements for note issue
4. 100% Marginal Reserve requirements for note issue, such as the Bank
Charter Act 1844 (UK)
5. Sanction on bank defaults and protection from creditors for many
months or even years, and
6. Central bank support for distressed banks, and government guarantee
funds for notes and deposits, both to counteract bank runs and to
protect bank creditors.

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FUNCTIONS:
As a central bank, the Reserve Bank has significant powers and duties to
perform. For smooth and speedy progress of the Indian Financial System, it
has to perform some important tasks. Among others it includes maintaining
monetary and financial stability, to develop and maintain stable payment
system, to promote and develop financial infrastructure and to regulate or
control the financial institutions for simplification, the functions of the
Reserve Bank are classified into the traditional functions, the development
functions and supervisory functions.

Traditional Functions of Reserve Bank of India RBI

Traditional functions are those functions which every central bank of each
nation performs all over the world. Basically these functions are in line with
the objectives with which the bank is set up. It includes fundamental functions
of the Central Bank. They comprise the following tasks.

1. Issue of Currency Notes: The RBI has the sole right or authority or
monopoly of issuing currency notes except one rupee note and coins of
smaller denomination. These currency notes are legal tender issued by
the RBI. Currently it is in denominations of Rs. 2, 5, 10, 20, 50, 100, 500,
and 1,000. The RBI has powers not only to issue and withdraw but even
to exchange these currency notes for other denominations. It issues
these notes against the security of gold bullion, foreign securities, rupee
coins, exchange bills and promissory notes and government of India
bonds.
2. Banker to other Banks: The RBI being an apex monitory institution
has obligatory powers to guide, help and direct other commercial banks
in the country. The RBI can control the volumes of banks reserves and
allow other banks to create credit in that proportion. Every commercial
bank has to maintain a part of their reserves with its parent's viz. the
RBI. Similarly in need or in urgency these banks approach the RBI for
fund. Thus it is called as the lender of the last resort.
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3. Banker to the Government: The RBI being the apex monitory body has
to work as an agent of the central and state governments. It performs
various banking function such as to accept deposits, taxes and make
payments on behalf of the government. It works as a representative of
the government even at the international level. It maintains government
accounts, provides financial advice to the government. It manages
government public debts and maintains foreign exchange reserves on
behalf of the government. It provides overdraft facility to the
government when it faces financial crunch.
4. Exchange Rate Management: It is an essential function of the RBI. In
order to maintain stability in the external value of rupee, it has to
prepare domestic policies in that direction. Also it needs to prepare and
implement the foreign exchange rate policy which will help in attaining
the exchange rate stability. In order to maintain the exchange rate
stability it has to bring demand and supply of the foreign currency (U.S
Dollar) close to each other.
5. Credit Control Function: Commercial bank in the country creates
credit according to the demand in the economy. But if this credit
creation is unchecked or unregulated then it leads the economy into
inflationary cycles. On the other credit creation is below the required
limit then it harms the growth of the economy. As a central bank of the
nation the RBI has to look for growth with price stability. Thus it
regulates the credit creation capacity of commercial banks by using
various credit control tools.
6. Supervisory Function: The RBI has been endowed with vast powers
for supervising the banking system in the country. It has powers to issue
license for setting up new banks, to open new braches, to decide
minimum reserves, to inspect functioning of commercial banks in India
and abroad, and to guide and direct the commercial banks in India. It
can have periodical inspections an audit of the commercial banks in
India.

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Developmental or Promotional Functions of RBI
Along with the routine traditional functions, central banks especially in the
developing country like India have to perform numerous functions. These
functions are country specific functions and can change according to the
requirements of that country. The RBI has been performing as a promoter of
the financial system since its inception. Some of the major development
functions of the RBI are maintained below.

1. Development of the Financial System: The financial system comprises

the financial institutions, financial markets and financial instruments.
The sound and efficient financial system is a precondition of the rapid
economic development of the nation. The RBI has encouraged
establishment of main banking and non-banking institutions to cater to
the credit requirements of diverse sectors of the economy.

2. Development of Agriculture: In an agrarian economy like ours, the

RBI has to provide special attention for the credit need of agriculture
and allied activities. It has successfully rendered service in this direction
by increasing the flow of credit to this sector. It has earlier the
Agriculture Refinance and Development Corporation (ARDC) to look
after the credit, National Bank for Agriculture and Rural Development
(NABARD) and Regional Rural Banks (RRBs).

3. Provision of Industrial Finance : Rapid industrial growth is the key to

faster economic development. In this regard, the adequate and timely
availability of credit to small, medium and large industry is very
significant. In this regard the RBI has always been instrumental in
setting up special financial institutions such as ICICI Ltd. IDBI, SIDBI and
EXIM BANK etc.

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4. Provisions of Training: The RBI has always tried to provide essential
training to the staff of the banking industry. The RBI has set up the
bankers' training colleges at several places. National Institute of Bank
Management i.e. NIBM, Bankers Staff College i.e. BSC and College of
Agriculture Banking i.e. CAB is few to mention.

5. Collection of Data: Being the apex monetary authority of the country,

the RBI collects process and disseminates statistical data on several
topics. It includes interest rate, inflation, savings and investments etc.
This data proves to be quite useful for researchers and policy makers.

6. Publication of the Reports: The Reserve Bank has its separate

publication division. This division collects and publishes data on several
sectors of the economy. The reports and bulletins are regularly
published by the RBI. It includes RBI weekly reports, RBI Annual Report,
Report on Trend and Progress of Commercial Banks India., etc. This
information is made available to the public also at cheaper rates.

7. Promotion of Banking Habits: As an apex organization, the RBI always

tries to promote the banking habits in the country. It institutionalizes
savings and takes measures for an expansion of the banking network. It
has set up many institutions such as the Deposit Insurance Corporation-
1962, UTI-1964, IDBI-1964, NABARD-1982, NHB-1988, etc. These
organizations develop and promote banking habits among the people.
During economic reforms it has taken many initiatives for encouraging
and promoting banking in India.

8. Promotion of Export through Refinance: The RBI always tries to

encourage the facilities for providing finance for foreign trade especially
exports from India. The Export-Import Bank of India (EXIM Bank India)
and the Export Credit Guarantee Corporation of India (ECGC) are
supported by refinancing their lending for export purpose.

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Supervisory Functions Of Reserve Bank Of India

The reserve bank also performs many supervisory functions. It has authority
to regulate and administer the entire banking and financial system. Some of its
supervisory functions are given below.

1. Granting license to banks: The RBI grants license to banks for carrying
its business. License is also given for opening extension counters, new
branches, even to close down existing branches.

2. Bank Inspection: The RBI grants license to banks working as per the
directives and in a prudent manner without undue risk. In addition to
this it can ask for periodical information from banks on various
components of assets and liabilities.

3. Control over NBFIs: The Non-Bank Financial Institutions are not

influenced by the working of a monitory policy. However RBI has a right
to issue directives to the NBFIs from time to time regarding their
functioning. Through periodic inspection, it can control the NBFIs.

4. Implementation of the Deposit Insurance Scheme: The RBI has set

up the Deposit Insurance Guarantee Corporation in order to protect the
deposits of small depositors. All bank deposits below Rs. One lakh are
insured with this corporation. The RBI work to implement the Deposit
Insurance Scheme in case of a bank failure.

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Reserve Bank Of India RBI'S Credit Policy

The Reserve Bank of India has a credit policy which aims at pursuing higher
growth with price stability. Higher economic growth means to produce more
quantity of goods and services in different sectors of an economy; Price
stability however does not mean any change in the general price level but to
control the inflation. The credit policy aims at increasing finance for the
agriculture and industrial activities. When credit policy is implemented, the
role of other commercial banks is very important. Commercial banks flow of
credit to different sectors of the economy depends on the actual cost of credit
and arability of funds in the economy.

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What Is The Credit Creation Process Of Commercial Bank With
Limitations?

Central bank is the first source of money supply in the form of currency in
circulation. The Reserve Bank of Indian is the note issuing authority of the
country. The RBI ensures availability of currency to meet the transaction
needs of the economy. The Total Volume of money in the economy should be
adequate to facilitate the various types of economic activities such as
production, distribution and consumption.

The commercial banks are the second most important sources of money
supply. The money that commercial banks supply is called credit money.

The process of 'Credit Creation' begins with banks lending money out of
primary deposits. Primary deposits are those deposits which are deposited in
banks. In fact banks cannot lend the entire primary deposits as they are
required to maintain a certain proportion of primary deposits in the form of
reserves with the RBI under RBI & Banking Regulation Act. After maintaining
the required reserves, the bank can lend the remaining portion of primary
deposits. Here bank's lend the money and the process of credit creation starts.

Suppose there are a number of Commercial Banks in the Banking System -

Bank 1, Bank 2, Bank 3, & So on.

To begin with let us suppose that an individual "A" makes a deposit of Rs. 100
in bank 1. Bank "1" is required to maintain a Cash Reserve Requirement of 5%
(Prevailing Rate) which is decided by the RBI's Monetary Policy from the
deposits made by 'A'. Bank "1" is required to maintain a cash reserve of Rs. 5
(5% of 100). The bank has now lend-able funds of Rs. 95(100 - 5). Let the
Bank "1" lend Rs. 95 to a borrower; say B. The method of lending is the same
that is bank 1 opens an account in the name of the borrower cheque for the
loan amount. At the end of the process of deposits & lending, the balance sheet
of bank reads as given below:-

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Balance Sheet of Bank “1"

Liabilities

Amount

Assets

Amount

A's deposits

100

Cash Reserve

Loan to "B"

95

Total

100

Total

100

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Now suppose that money that borrowed from bank "1" is paid to individual
"C" in settlement of his past debts. The individual "C" deposits the money in
his bank say, bank 2. Now bank 2 carries out its banking transaction. It keeps a
cash reserve to the extent of 5%, that is Rs. 4.75 (5% of 95) and lend Rs. 90.5
to a borrower D. At the end of the process the balance sheet of Bank 2 will be
look like:-

Balance Sheet of Bank "2"

Liabilities

Amount

Assets

Amount

B's deposits

95

Cash Reserve

4.75

Loan to "C"

90.5

Total

95

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Total

95

The amount advanced to D will return ultimately to the banking system, as

described in case of B and the process of deposits and credit creation will
continue until the reserve with the banks is reduced to zero. The final picture
that would emerge at the end of the process of deposit & credit creation by the
banking system is presented in the consolidated balance sheet of all banks are
as under:-

The combined Balance sheet of Banks

Bank

Liabilities Deposits

Assets Credits

Reserve

Total Assets

Bank 1

100

95

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100

Bank 2

95

90.5

4.75

95

Bank 3

90.5

85.98

4.52

90.5

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-

Bank n

00

00

00

00

Total

2,000

1,900

100

2,000

It can be seen from the combined balance sheet that a primary deposits of Rs.
100 in a bank 1 leads to the creation of the total deposit of Rs. 2,000. The
combined balance sheet also shows that the banks have created a total credit
of Rs. 2,000. And maintained a total cash reserve of Rs.100.Which equals the
primary deposits. The total deposit created by commercial bank constitutes
the money supply by the banks.

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CONCLUSION: -

To conclude, we can say that credit creation by banks is one of the important
& only sources to generate income. And when the reserve requirement
increased by the central bank it would directly affect on the credit creation by
bank because then the lend-able funds with the bank decreases and vice versa.
We had done calculation and also shown various diagram and figures which
indicates the growth and different views through it.

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