Money creation (or ** creation or credit creation) by the banks is determined by (i) the amount of the initial fresh deposits and (ii) the Legal Reserve Ratio (LRR), the minimum ratio of ** legally required to be kept as liquid assets by the banks. It is assumed that all the money that goes out of banks is redeposited into the banks. Let the LRR be 20% and there is fresh deposits of Rs.10,000. As required the bank keep 20% i.e., Rs.2000 as reserves. Suppose the bank lend the remaining Rs.8,000. Those who borrow, use this money for making payment. As assumed those who receive payments, put the money back into the banks. In this way, banks receive fresh deposits of Rs.8,000. The banks again keep 20% i.e. Rs.1600 as reserves and lend Rs.6,400, which is also 80% of the last **. The money again comes back to the banks leading to a fresh ** of Rs.6,400. The money goes on multiplying in this way, and ultimately total money creation is Rs.50,000.
Given the amount of fresh *** and the LRR, the total money creation is:
Total Money Creation = Initial Deposits x 1/LRR
