Question

Explain the process of credit creation. What are the institutions which influence credit creation?

Answer 1

The process of credit creation is started with a simple deposit, one deposit in a financial institution such as a bank will start the process of credit creation. When a person makes a deposit of, for example 100 dollars, the bank uses this money in two ways, firstly the bank  has a cash reserve ratio, this is a fraction of the deposit that the bank must keep as reserves, for example 10 percent, this means out of the 100 dollar deposit the bank must keep 10 dollars as a reserve. The rest of the money which is 90 dollars will be lent out, this process will continue indefinitely till the following banks can make loans. So at each step a deposit will be kept as a reserve and the other proportion will be lent out. Therefore the banks create credit by the use of deposits.

A prime example of a financial institution is a bank.