Credit creation process of commercial banks entails lending cash to creditworthy borrowers, who pays interests to the banks. Subsequent to paying the interest to the bank, the borrower can use the credit to buy a product or service, through electronic transfer or cheque. The vendor, who receives the funds, then makes a fresh deposit in the financial segment, leading to credit growth. Thus, credit creation can be defined as the growth of bank deposits through the practice of offering more loans, investments and advances (Somashekar, 2009).
The degree of credit creation mostly relies on the monetary policy of a nationâs Central Bank. The Central Bank has the authority to control the amount of money in flow and, thus, the amount of credit that the banks make (Dwivedi, 2010). Besides, the Central Bank possesses strong weapons, such as, open market operations and the bank rate, with which it can apply control on the extension and reduction of credit by the banks. Thus, the capacity of a bank to generate credit may encounter various restrictions. However, we can not undermine the significance of credit creation by banks, in an economy. This is because credit creation, by banks, has extensive effects on the running of the economy, particularly, in the business area.
If the amount of credit grows rapidly, some household and business overheads may be fueled because the level of AD becomes affected. Besides, inflation may arise from surplus credit or money in a market which is already working at its ability (Somashekar, 2009). Hence, strict government regulations on the volume of money must be put in place. This will avoid surplus credit, which may cause inflation. Conversely, little credit growth can smother processes. The planned regulation of interest rates on deposits and loans, by the RBA, is an essential mode of guaranteeing that the intensification in economic activity and AD is not too rapid or slow so as, to guarantee stability. This is a significant, stabilising aspect of monetary policy.
The diagram below (figure 1) demonstrates how RBA can employ reduced interest rates in fueling AD. As seen in the diagram, a decrease in interest rates is apt to raise national production from GDP0 to GDP1, and increase expenditure from AD0 to AD1.
References
Dwivedi, D 2010, Macroeconomics: theory and policy, McGraw Hill, New Delhi.
Somashekar, N 2009, Banking, New Age International Publishers, New Delhi.