The process of credit creation can be better' understood with the help of the following numerical example. For simplicity, let us assume that the entire commercial banking system is a single unit called 'banks'.
Suppose, initially the public deposited Rs.1,000 with the banks. The banks kept a portion of these deposits with themselves as cash reserves (in accordance with CRR and SLR) and extend the rest as loans to the borrowers. Let us assume that the Legal reserve Ratio (LRR) is 20%, or 0.20 and the banks have maintained exactly the same amount as cash reserves (i.e. neither more nor less).
This implies that banks will keep 20% of the deposits received as reserves and the rest is given out as loans. In other words, out of Rs.1,000 (initial deposits), banks kept Rs. 200 with themselves as reserves and the balance amount of Rs.800 (Rs.1,000 - Rs. 200) is given as loans. Also suppose that all the transactions taking place in the economy are routed only through banks. Thus, the money spent by the borrowers again comes back to the banks as deposits. Hence, there is an incretnent in the demand deposits with the banks by Rs. 800 (in the second round). Therefore, now the total deposits with the banks rises to Rs.1,800 (Rs.1,000 + Rs.800). Now, out of the new deposits of Rs.800, the banks will keep 20% as reserves and the remaining amount is lent out i.e. Rs.160 is kept as reserves and the remaining Rs.640 is extended as loans. When the borrower spends this borrowed amount either by cheques, demand drafts, etc. This amount is routed through the banks. Therefore, the money spent by the borrowers comes back to the bank and the total deposits increase to Rs.2,440 (i.e. Rs.1800 + Rs.640). The same process continues and with each round the total deposits with the banks' increases. However, in every subsequent round, the cash reserves diminish. The process comes to an end when the total cash reserves (aggregate of cash reserves from the subsequent rounds) become equal to the initial deposits of Rs.1,000 that was initially held by the banks.
