Money/Credit creation - The Process of multiplying the deposits by commercial bank is called credit creation.

Money creation or deposit creation or credit creation by the bank is determine by – 

(i) The amount of the initial fresh deposits and 

(ii) The Legal Reserve Ratio (LRR) i.e. the minimum ratio of deposit legally required to be kept as cash by banks.

It is assumed that all the money that goes out of bank is re-deposited in to the banks.

Let the LRR be 20% and there is a fresh deposit of Rs 10,000. As required, the banks keep 20% i.e. Rs 2,000 as cash. Suppose the bank lend the remaining Rs 8000. Those who borrow use this money for making payments. As assumed who receive payments put the money back in to the bank. In this way bank receive fresh deposit of Rs 8,000.

The bank again keeps the 20% i.e. Rs 1,600 as cash and lends Rs 6,400 which is also 80% of the last deposit. The money again comes back to the banks leading to a fresh deposit of Rs 6,400. The money goes on in multiplying in this way, and ultimately total money creation is Rs 50,000.

Given the amount of fresh deposit and the LRR, the total money creation formula is:

Money creation = Initialde posit x 1 / LRR

Money creation =10000 x 1 / 20%

= 10000 x 1/20 x 100

= Rs 50,000

Limitations to credit creation - There are following limitations to credit creation by banks:

1. The total amount of cash reserves in the banking system. Larger the cash reserves more will be the credit creation. 

2. Cash reserve ratio fixed by the central bank. More is the ratio, less is the power to create credit and vice versa. 

3. Banking habits of the people of the country- It means banking transactions through cheques, drafts, bills etc. Good banking habit results in keeping smaller amount of cash with the banks and therefore, more can be lent. This will create large credit.