When a bank creates deposits, the borrowers are free to withdraw their funds and issue cheques against others. Some of the cheque-receivers may have accounts with the same bank. In that case, the money withdrawn by cheques may be deposited with the bank. Thus, there will be no outflow of cash.
The created deposits on the one hand are reduced by the amount of cheques but on the other hand, primary deposits are increased by the same amount which enables a bank to create more credit. Let us assume that the bank has excess reserves of Rs.1, 000 which enables it to create deposits for that amount against a borrower.
When a borrower issues a cheque to a person, the latter sends the cheque to the bank to deposit the money in his accounts, if he maintains an account with the bank. In that case, the primary deposits are increased by Rs.1, 000 and the bank again can lend the amount minus the minimum reserves a bank must preserve.
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If we suppose that the minimum reserve ratio is fixed at 10 per cent, the bank in this case can lend out Rs.900 to the intending borrowers.
If we assume that the whole amount of the loan is spent by the borrowers and the receivers of payments from them also have bank accounts then the whole amount would come back to one bank or the other i.e., to the banking system as primary deposits.
These banks then, after setting aside 10 per cent as reserves, would re-lend the rest i.e., they would lend out Rs.810. In this way there would be a continuous process of credit creation which would come to end only when no bank in the banking system has cash reserves in excess of the minimum reserve ratio.
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In the process of expansion of credit these will be outflow of cash and every bank should maintain a certain percentage of deposits as reserves in order to meet unforeseen circumstances i.e., when outflow of cash will be larger than inflow.
When cash reserves exceed the minimum reserve ratio, the bank can lend more, even by reducing the rate of interest. When reserves fall short of the acceptable proportion, the bank should curtail loans at once suitably altering the rate of interest.
There is a controversy regarding the bank’s power to create credit. Hartley Wilters holds that the initiative in the creation of credit lies with the bank. But according to Walter Leaf and Canan, in the ultimate analysis, the initiative lies with the depositors, whose money the bank uses to grant loans.
If the depositors withdraw their primary deposits all at a dme, the bank’s position as a lender becomes vulnerable. Actually even considering this controversy there can be no doubt about the bank’s power of credit creation in view of the analysis of multiple expansion of credit noted above.
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The initiative in credit creation may come from the bank itself or may come from the public but without the consent of the bank, no credit can be created.