- Money creation by commercial banks is based on “fractional reserve banking”.
- Banks keep only a fraction of deposited money as reserve.
- The rest is lent to others.
- This lending creates new deposits, which are again partially lent.
- This process continues, increasing the total money supply.
- The money multiplier shows how much money supply increases for each unit of monetary base.
- Money Multiplier = (1 + currency-deposit ratio) / (currency-deposit ratio + reserves-deposit ratio).
- Example: If RBI issues Rs. H, money supply can increase to 5H/3 with a multiplier of 5/3.