What Is Credit Creation~ How Credit is created And Limitations

CREDIT CREATION
WHAT IS CREDIT: Credit money is the amount agreed upon to pay later. It is issued by Commercial banks and takes in the form of cheques. Credit expansion takes place by means of using cheques.

HOW CREDIT IS CREATED
Assumptions

• Reserved Ratio is 10%

• One Commercial Bank in area (M.C.B)

• Initial deposit Rs.1000 Suppose Mr. Ahmed deposits Rs.1000 in bank, 10% of which that become Rs 100 bank sent to central bank as cash reserve. Now bank has only Rs 900 to be used for advancing loans. Now Mr. Babar borrows this Rs.900 and makes payment to Mr. Khalid, now Mr. Khalid receives the cash Rs.900 and deposit in its account with the same bank. (Because area has only one commercial bank) Now M.C.B bank receives that cash of Rs. 900. At this stage the bank has net deposit of Rs.1900 (1000 + 900) while the original deposit is Rs.1000

Maximum expansion of credit = original deposit x 1_______

Reserve ratio

Maximum expansion of credit = 1000 x 1 / .10 = 10,000


LIMITATION OF CREATION OF CREDIT

By studying the process of Creation of Credit the reader might have understood: “The Bank reap which they never soon”

• RESTRICTIONS ON CREDIT CREATION There are some limiting Cases mentioned as under:

• CASH AVAILABLE IN THE ECONOMY
The Creation of Credit as Principle depends on the basis of Cash. The more will be Cash available. The higher will be the volume Creation of Credit But what a volume. A bank Can posses can be Controlled by the Central bank. 

REQUIRED CASH BY THE PEOPLE Another restriction depends on the liquidity habit of the people. That how much people are habitual to use more cash and less cheques. The bank will not be capable, to have more cash. Therefore, it will not be capable to create more Credit
MINIMUM LIMIT OF SECURED LIQUIDITY RATIO Limitation on the Creation of Credit is that minimum ratio of Cash which is traditionally and legally is a must on the part of bank to maintain so that it could meet the Cash demand. Of its account holder and could maintain its Credibility.

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