Credit Creation Theory

(Kalecki and Schumpeter)

Dr. Mayank Malviya

 Need for Credit Creation
 Commercial banks are called the factories of
credit.
 They advance much more than what the collect
from people in the form of deposits.
 Through the process of credit creation,
commercial banks provide finance to all
sectors of the economy thus making them
more developed than before.

Dr. Mayank Malviya

 In this theory financial system plays a positive
role by providing finance or credit through
creation of credit in anticipation of savings.
 The investment is financed through created
credit.
 The basis of credit money is the bank deposits.
 The bank deposits are of two kinds viz.,
1. Primary deposits, and
2. Derivative deposits

Dr. Mayank Malviya

 Primary Deposits
 Primary deposits arise or formed when cash or
cheque is deposited by customers.
 When a person deposits money, the bank will
credit his account.
 The customer is free to withdraw the amount
whenever he wants.
 These deposits are called “primary deposits” or
“cash deposits.”

Dr. Mayank Malviya

 It is out of these primary deposits that the
bank makes loans and advances to its
customers.
 The initiative is taken by the customers
themselves.
 In this case, the role of the bank is
passive.
 So these deposits are also called “passive
deposits.”
Dr. Mayank Malviya
 Derivative Deposits
 Bank deposits also arise when a loan is granted
or when a bank discounts a bill or purchase
government securities.
 Deposits which arise on account of granting
loan or purchase of assets by a bank are called
“derivative deposits.”
 Since the bank play an active role in the
creation of such deposits, they are also known
as “active deposits.”

Dr. Mayank Malviya

 Credit Creation
 When the bank buys government securities, it
does not pay the purchase price at once in
cash.
 It simply credits the account of the government
with the purchase price.
 The government is free to withdraw the
amount whenever it wants by cheque.
 The power of commercial banks to expand
deposits through loans, advances and
investments is known as “credit creation.”
Dr. Mayank Malviya
 Process of Credit Creation
 The banking system as a whole can create
credit which is several times more than the
original increase in the deposits of a bank.
 This process is called the multiple-expansion
or multiple-creation of credit.
 Similarly, if there is withdrawal from any one
bank, it leads to the process of multiple-
contraction of credit.

Dr. Mayank Malviya

 The process of multiple credit-expansion can
be illustrated by assuming
a. The existence of a number of banks, A, B, C
etc., each with different sets of depositors.
b. Every bank has to keep 10% of cash reserves,
according to law, and
c. A new deposit of ₹ 1,000 has been made with
bank A to start with.

Dr. Mayank Malviya

 Suppose, a person deposits ₹ 1,000 cash in
Bank A. As a result, the deposits of bank A
increase by ₹ 1,000 and cash also increases by
₹ 1,000. The balance sheet of the bank is as
follows:
Balance Sheet of Bank A
Liabilities ₹ Assets ₹
New Deposit 1,000 New cash 1,000

Total 1,000 1,000

Dr. Mayank Malviya

 Suppose bank had given loan to Mr. X.
 Under the double entry system, the amount of
₹ 1,000 is shown on both sides.
Balance Sheet of Bank A
Liabilities ₹ Assets ₹
Deposit 1,000 New Cash 100
Loan to X 900
Total 1,000 1,000

Dr. Mayank Malviya

 Suppose X purchase goods of the value of ₹ 900 from Y and pay cash.
 Y deposits the amount with Bank B.
 The deposits of Bank B now increase by ₹ 900 and its cash also increases
by ₹ 900.
 After keeping a cash reserve of ₹ 90, Bank B is free to lend the balance of ₹
810 to any one.
 Suppose bank B lends ₹ 810 to Z, who uses the amount to pay off his
creditors. The balance sheet of bank B will be as follows:

Balance Sheet of Bank B

Liabilities ₹ Assets ₹
Deposit 900 Cash 90
Loan to Z 810
Total 900 900
Dr. Mayank Malviya
 Suppose Z purchases goods of the value of ₹ 810
from S and pays the amount.
 S deposits the amount of ₹ 810 in bank C.
 Bank C now keeps 10% as reserve (₹ 81) and lends ₹
729 to a merchant.
 The balance sheet of bank C will be as follows:
Balance Sheet of Bank C
Liabilities ₹ Assets ₹
Deposit 810 Cash 81
Loan to 729
Merchant
Total 810 810
Dr. Mayank Malviya
 Thus looking at the banking system as a
whole, the position will be as follows:

Name of Deposits Cash Loan (₹)

bank (₹) Reserve
(₹)
Bank A 1,000 100 900
Bank B 900 90 810
Bank C 810 81 729
Total 2710 271 2439
Dr. Mayank Malviya