Comprehensive Study Notes on Money and Credit Creation

Definition and Significance: Money creation, also known as credit creation, is documented as one of the most vital and fundamental activities performed by commercial banks.
The Process of Creation: Commercial banks possess the unique capability to create credit through a specific process. This created credit effectively results in total deposits that are far in excess of the initial cash deposited by the public, known as Primary Deposits.

To understand the mechanics of how money is created within the economy, two primary assumptions are established:

Unitary Banking System: The entire commercial banking infrastructure is treated as a single, consolidated unit. Throughout the analysis, this entire system is simply referred to as 'Banks'.
Economic Routing via Banks: All economic activity is assumed to be fully integrated with the banking system. Specifically:
- Every receipt in the economy is eventually deposited back into the 'Banks'.
- Every payment made within the economy is processed through the 'Banks' using cheques.
- This implies a closed-loop system where cash does not leak out of the banking environment.

Utilization of Deposits: The deposits held by 'Banks' are not static; they are utilized as the capital base for granting loans to various borrowers.
Method of Granting Loans: Commercial banks do not typically provide loans by handing over physical cash to the borrower. Instead, the process involves:
- Opening a specific deposit account in the the name of the borrower.
- Crediting the approved loan amount directly into that newly created account.
Secondary Deposits: The account balance resulting from the loan amount credited by the bank is formally termed a Secondary Deposit or a Derivative Deposit. Because the bank creates these deposits through the act of lending, they are "derived" from the bank's own credit-granting activities.

Lending Constraints: Banks are legally prohibited from using the entire volume of their deposits for the purpose of lending. They must adhere to strict regulatory requirements.
Definition of Legal Reserve Ratio (LRR): It is legally compulsory for banks to maintain a specific minimum fraction of their total deposits in the form of liquid reserves. This fraction is termed the Legal Reserve Ratio ( $LRR$ ).
Alternative Terminology: The Legal Reserve Ratio is also frequently referred to as the:
- Reserve Deposit Ratio
- Reserve Ratio ( $RR$ )
- $ROR$
Authority and Regulation: The specific value of the $LRR$ or $RR$ is fixed and regulated by the Central Bank of the country.
Reserve Magnitude: Banks do not maintain $100\%$ reserves against their deposits. Instead, they keep only the precise extent of reserves mandated by the Central Bank's regulations. This fractional reserve system is what enables the multiplication of credit.

Understanding the distinction between these two types of deposits is crucial for understanding the total money supply within the banking system.

Primary Deposits:
- Definition: These are the actual cash deposits made by the public into commercial banks.
- Account Types: These deposits are held in various forms, including savings accounts, current accounts, term deposit accounts, and other related deposit schemes.
- Economic Indicator: Primary Deposits are representative of the actual savings of the depositors held with the bank.
Secondary Deposits (Derivative Deposits):
- Definition: These are deposits that arise specifically because of the loans granted by the banks to borrowers.
- Economic Indicator: Secondary Deposits indicate the total borrowings of the individuals or entities from the banks.
The Aggregate Relationship:
- The total demand deposits of commercial banks are calculated as the sum of both types of deposits: $\text{Total Demand Deposits} = \text{Primary Deposits} + \text{Secondary Deposits}$
The Multiplier Effect:
- Commercial banks have the power to create secondary deposits through the lending process that are many times larger than their actual cash reserves.
- Consequently, in a functioning credit-creation environment, Secondary Deposits are always greater in volume than Primary Deposits.