The process by which the banking system expands the initial deposit base into a larger volume of money through repeated lending, and the multiplier that links the central bank's reserve money to the total money supply.
- When a bank receives a deposit, it keeps a fraction as reserves (the CRR and SLR) and lends out the rest; the loan is re-deposited elsewhere and lent again, multiplying the money supply.
- The money multiplier is broadly the ratio of broad money (M3) to reserve money (M0); a lower reserve ratio means a higher multiplier and more credit creation.
- The maximum theoretical expansion equals the initial deposit divided by the reserve ratio; in practice leakages (cash held by the public, excess reserves) reduce it.
- Raising the CRR cuts the funds available for lending, lowers the multiplier and tightens concept monetary policy; lowering it does the reverse.
- This explains how the RBI's monetary aggregates respond to changes in reserve requirements and the policy rate.
The credit-creation mechanism and the inverse link between the reserve ratio and the money multiplier are common conceptual money-and-banking questions.
Credit creation (banks expanding deposits through lending) does not mean banks print money; a higher CRR lowers the multiplier, it does not raise it.
Banks multiply deposits by lending out the part not held as reserves; the money multiplier (M3 over M0) falls when the reserve ratio rises.