Fresh Deposits, a CRR Hike and the Limits of Credit Creation in a Purnia Branch
A newly opened branch of a scheduled commercial bank in Purnia receives ₹200 crore of fresh primary deposits in a single quarter. The cash reserve ratio is 4 per cent and the statutory liquidity ratio is 18 per cent. In the first quarter the branch keeps no excess reserves and lends every rupee it legally can; borrowers deposit their loan money in the same banking system. In the next quarter the Reserve Bank, worried about consumer price inflation running at 7 per cent, raises the cash reserve ratio to 5 per cent. The branch manager tells the local chamber of commerce that the fresh deposits will create ₹5,000 crore of total deposits in the system and that the CRR hike "will destroy money". A trader replies that banks create money out of nothing and could lend without limit if they found enough customers. Meanwhile, several borrowers in the district have postponed expansion plans because demand for their products is weak.
1. Show the first three rounds of deposit creation for the ₹200 crore at a CRR of 4 per cent, then compute the total deposits and total credit created in the banking system.
Read the worked answer
Each round, the bank keeps 4% as cash reserves and lends the remaining 96%.
| Round | New deposit (₹ crore) | Reserves kept (₹ crore) | Loan made (₹ crore) |
|---|---|---|---|
| 1 | 200.00 | 8.00 | 192.00 |
| 2 | 192.00 | 7.68 | 184.32 |
| 3 | 184.32 | 7.37 | 176.95 |
Beyond round 3 the same logic repeats on smaller amounts. The total is a geometric series with ratio 0.96: 200 × 1/(1 − 0.96) = 200 × 25 = ₹5,000 crore of total deposits. The money multiplier is 1/CRR = 1/0.04 = 25.
Credit created = total deposits − the cash that must sit as reserves against the original deposit = 5,000 − 200 = ₹4,800 crore.
The manager's ₹5,000 crore figure is therefore correct as a potential maximum, but only under the stated assumptions: no currency leakage, no excess reserves, and borrowers redepositing within the same system. The ₹200 crore of cash does not vanish; it becomes the reserve base that supports the ₹5,000 crore of deposits.
2. Recompute total deposits and credit at a CRR of 5 per cent, and explain why the credit actually created in Purnia will normally be smaller than either estimate.
Read the worked answer
At CRR 5%: multiplier = 1/0.05 = 20. Total deposits = 200 × 20 = ₹4,000 crore; credit = 4,000 − 200 = ₹3,800 crore. The CRR hike removes ₹1,000 crore of potential deposits and ₹1,000 crore of potential credit from the system.
The manager's "destroy money" claim is directionally right but overstated: no existing deposit is destroyed, only the capacity to create new deposits is reduced, because each rupee of reserves now supports fewer deposit rupees.
Actual creation will fall short of ₹4,000 crore because the multiplier's assumptions are unrealistic:
- Currency leakage: the public holds part of every loan as cash, so it never returns as a deposit.
- Excess reserves: banks rarely lend to the last rupee; prudential buffers and slow credit demand leave idle reserves.
- SLR of 18%: though the textbook multiplier counts only CRR, SLR pre-empts a large slice of deposits for government securities, shrinking lendable funds.
- Weak borrower demand: as in the district's postponed expansions, a willing borrower is needed; reserves cannot force lending.
The honest answer is a range, not a single number.
3. Evaluate the trader's claim that banks create money out of nothing and could lend without limit. What ultimately restricts a single bank and the banking system as a whole?
Read the worked answer
The trader is half right. When a bank lends, it credits the borrower's account, so a loan and a deposit appear simultaneously - the deposit is genuinely created by the act of lending, not taken from a pre-existing pile of cash.
The word "nothing" is where the claim fails. Every created deposit must be backed by reserves: cash in the bank's vault or its balance with the Reserve Bank. With a 4% CRR, $... ₹100 of reserves supports ₹2,500 of deposits; at 5%, only ₹2,000. The limit is set by high-powered money (currency with the public plus bank reserves) and the reserve ratio, which is why the multiplier is 1/CRR and not infinity.
A single branch faces a further constraint: if it lends far beyond its own deposit base, it must settle payments to other banks, and it can do so only by drawing down reserves - it cannot create reserves, only the central bank can. Finally, lending needs creditworthy customers. Reserves can be abundant and credit still stagnant, which is exactly the situation in the district where borrowers have postponed investment. So the binding constraints are reserves, the reserve ratio, and the demand for loans - not the bank's willingness alone.