Process of Credit Creation - Credit Creation, Indian Financial system Video Lecture | Indian Financial System - B Com

hi everybody let's in this video
understand a primary function of banks
which is credit creation how banks can
create money out of thin air and
increase the money supply just like that
it seems very very interesting concept a
lot of people think this is really quick
it's not it's very sustainable a process
known as fractional reserve banking
right so we have a bank in the middle
there we know that one of the key
functions of a bank is to bring together
savers with borrowers sailors will
deposit money in banks and will gain a
rate of return back from banks as a
result banks will then create loans from
those savings on lend to borrowers and
will charge an interest rate to
borrowers as a result the whole idea is
that the interest rates charged to
borrowers will be greater than the rate
of return given to savers the difference
will be the profit that bands make and
we know that their primary objective is
to make profit great that's how it works
but let's dig deeper into this process
let's understand this idea of fractional
reserve banking well let's take an
individual saver who deposits a hundred
pounds in the bank the bank will then
decide and make a very careful
calculation of how much of that hundred
pounds needs to stay in the bank knowing
that the individual saver is unlikely at
one time to demand all of their savings
back more likely that individual say or
come and want to withdraw some of that
hundred pounds to finance whatever
spending in the economy that that saver
wants to do but unlikely that a hundred
pounds will be withdrawn at once so the
bank decides that maybe only ten pounds
of that needs to be left in the bank in
case that sabre comes and demands some
bit the rest of it can be lent out to
borrow is mighty pounds borrowers want
money to spend in the economy when they
spend that generates income for somebody
else
at which point that 90 pounds can end up
back in the bank as a deposit again all
of a sudden we are increasing the money
supply well only a hundred pounds
existed before we've now got 90 pounds
on top so 190 pounds in the money supply
compared to just a hundred pounds before
remembering that deposits form a key
part of money supply so now 90 pounds
are back into the bank the bank will
think okay only nine pounds of that I
need to keep in the bank
in case that individual server comes
back and depends on the BES aids the
rest can be lent out to individuals lent
out to borrowers who are there buy goods
and services that generates income for
somebody else and eventually that 81
pounds will come back in the form of a
deposit in the bank and that process
keeps happening and happening and
happening so you get the idea of how
deposits can be turn into loans and will
come back into the bank as a form of
deposit this process continues what we
can actually work out is how much extra
money can be created from an initial
deposit using an equation called the
money multiplier and the money
multiplier equation is this the money
multiplier is one over the reserve ratio
or the reserve requirement in the UK the
reserve ratio is not set by the Bank of
England yet it's not there's no
regulation in place at all
but in the u.s. there is a regulation of
how much commercial banks must keep in
their banks when deposits are made and
that is 10% in the USA in the UK is not
there in my example you can see that the
reserve ratio is 10% any time deposits
have been put into the bank ten percent
of it have been kept in the bank the
rest has been meant out so my example
the money multiplier is one over 10
percent ie one over the North Point one
which gives you a value of 10 so if you
multiply the initial deposit by 10 you
get a thousand pounds and that is that
money supply as a result of an initial
deposit being put in a bank a thousand
pounds of money there exists in the
economy to work out the increase in the
money supply from a 100 pound deposit
with a money multiplier of 10 you need
to take away
100 pounds from whatever figure you get
so 10 times 100 gives you 1,000 pounds
minus the initial deposit which is a
hundred pounds because that already
existed means you have nine hundred
pounds of brand-new money in the money
supply so that is fractional reserve
banking guys and this happens on a daily
basis when we put our money into bank
accounts some of it is kept in the bank
and the rest of it is lent
individuals and that keeps happening in
a circle circle circle creating new
money out of nothing you might see but
this is very sustainable as long as we
all have faith in banks as long as we
all don't go to the bank at once and
demand all of our money bank if we do
that we know banks don't have all that
money then lending a lot of that out to
other individuals
that's called a bank run so unless we do
that this system will be absolutely fine
if we all go to the bank and demand more
money that's called a bank run and
that's when this fractional reserve
system will completely break down so the
whole idea of fractional reserve banking
is that it's based on trust it's based
on faith that individual savers will
never at once come and demand huge
chunks of their savings back at one go
as long as we don't do that this system
is very very sustainable and it leads to
increases the money supply which can
facilitate growth in the economy thank
you so much watching guys hope that
makes sense very interesting stuff I'll
see you all in the next video