EconomicsCBSE Class 12 · Money and Banking

Money Creation by Commercial Banks and the Money Multiplier (Class 12)

Updated 15 October 2026 · Fact-checked

Commercial banks create money because they keep only a fraction of deposits as reserves and lend the rest; the loans return as new deposits and are lent again. Total deposits = initial deposit × 1 ÷ LRR, so the money multiplier is 1 ÷ LRR. With a 20% reserve ratio, ₹100 of new deposits can become ₹500.

Each loan returns as a new deposit, so ₹100 grows to ₹500 until reserves reach ₹100; with LRR 20%, the multiplier 1 ÷ 0.2 is 5.

Illustration drawn for QuestionBuddy.

Understand Money Creation by Commercial Banks

Commercial banks. They accept deposits and lend part of them. They pay depositors a lower interest rate than they charge borrowers; the difference (the spread) is the bank's profit.

Bank balance sheet. Assets (left) = reserves (cash and deposits with the RBI) + loans; liabilities (right) = deposits; net worth = assets − liabilities.

Money supply (M1) = currency held by the public + net demand deposits with commercial banks. When banks create deposits, money supply rises.

Why there is a limit. The RBI requires banks to keep a percentage of deposits as reserves: the Cash Reserve Ratio (CRR), also called the required or legal reserve ratio (LRR). Banks must also keep some liquid assets (SLR). Only the rest can be lent.

The process (NCERT style, LRR 20%, initial deposit ₹100).

Round	Deposits	Required reserves (20%)	Loans
1	100.00	20.00	80.00
2	180.00	36.00	64.00
...	...	...	...
Last	500.00	100.00	400.00

Each loan comes back as a deposit, part is kept as reserve and the rest is lent again. The process stops when required reserves equal the initial deposit (20% of ₹500 = ₹100). Final balance sheet: reserves ₹100 + loans ₹400 = deposits ₹500.

Money multiplier = 1 ÷ LRR (here 1 ÷ 0.2 = 5). Total deposits = initial deposit × money multiplier; credit created = total deposits − initial deposit.

Alternative 'rounds' presentation often used in board answers: with LRR 10% and an initial deposit of ₹1,000, deposits grow 1,000 + 900 + 810 + ... = ₹10,000; loans 900 + 810 + 729 + ... = ₹9,000; reserves 100 + 90 + 81 + ... = ₹1,000.

Assumptions. All loans are redeposited in the banking system; banks lend all excess reserves; LRR is the only leakage.

Policy link. A higher CRR lowers the multiplier and money creation (if NCERT's CRR rises from 20% to 25%, ₹100 of reserves supports only ₹400 of deposits and ₹300 of loans).

Money Creation by Commercial Banks: key facts

Money multiplier: Money multiplier = 1 ÷ LRR; LRR as a fraction (20% → 0.2).
Total deposits: Total deposits = Initial deposit × 1 ÷ LRR; Also = reserves ÷ LRR.
Credit created: Credit created = Total deposits − Initial deposit; = total loans.
Balance sheet identity: Reserves + Loans = Deposits (+ net worth); Assets = liabilities.
M1: M1 = Currency held by the public + Net demand deposits; Syllabus definition of money supply.

How to answer Money Creation by Commercial Banks questions

Credit creation is a regular 3- or 4-mark numerical: find total deposits or credit, find LRR or initial deposit from given totals, or show the rounds table.

1Convert LRR to a fraction (25% → 0.25) and find the multiplier 1 ÷ LRR.
2Total deposits = initial deposit × multiplier; credit = total deposits − initial deposit.
3To find LRR: multiplier = total deposits ÷ initial deposit; LRR = 1 ÷ multiplier.
4To find the initial deposit from credit created: initial = credit ÷ (multiplier − 1).
5For a rounds table, show at least three rounds (deposit, reserve, loan) and the totals.
6Check: total reserves must equal the initial deposit.

Money Creation by Commercial Banks in real life

The idea, met in an everyday situation. Answer the question in your own words, then compare with the model answer. The one-line hook is what to remember.

One deposit, many loans

Suppose your grandmother deposits ₹1,000 in a bank, and the bank must keep 10% as reserve. It lends ₹900 to a tailor, who pays a cloth seller, who deposits it in the bank; the bank keeps ₹90 and lends ₹810 to a vegetable vendor, and so on.

How much in total deposits and loans can the banking system create?

Try it first, then show the solutionSolution

Multiplier = 1 ÷ 0.10 = 10.
Total deposits = 1,000 × 10 = ₹10,000.
Loans = 10,000 − 1,000 = ₹9,000.

Answer: Up to ₹10,000 of deposits and ₹9,000 of loans, because each loan returns as a deposit and is partly lent again until reserves total ₹1,000.

Memory hook: A rupee deposited can travel round the bank many times.

Tricks to remember Money Creation by Commercial Banks

Short memory aids. Say each one aloud once, then use it on a question the same day.

1 over LRR
Multiplier = 1 ÷ LRR: 10% → 10, 20% → 5, 25% → 4, 12.5% → 8.
Use it when: Quick MCQs.
Stop rule
Creation stops when total reserves = initial deposit.
Use it when: Checking answers.
Credit = deposits minus the first deposit
The initial deposit was not created by banks; everything above it was.
Use it when: Credit created vs total deposits.

Money Creation by Commercial Banks: solved examples

Ordered from board level to HOTS. Try each one before you open the solution.

Example 1: Multiplier from LRR · 1 mark · MCQBoard level

If the legal reserve ratio is 25%, the money multiplier is:
(a) 0.25
(b) 2.5
(c) 4
(d) 25

Try it first, then show the solutionSolution

1 ÷ 0.25 = 4.

Answer: (c) 4

Example 2: Total deposits and credit · 3 marks · Short answerBoard level

Initial deposits of ₹2,000 crore are made with commercial banks and the LRR is 20%. Calculate total deposits and credit created. (3 marks)

Try it first, then show the solutionSolution

Multiplier = 1 ÷ 0.2 = 5.
Total deposits = 2,000 × 5 = ₹10,000 crore.
Credit = 10,000 − 2,000 = ₹8,000 crore.

Answer: Total deposits ₹10,000 crore; credit created ₹8,000 crore.

Example 3: Rounds table · 4 marks · Short answerHarder board level

Show the process of credit creation for an initial deposit of ₹1,000 with an LRR of 10%, for three rounds and in total. (4 marks)

Try it first, then show the solutionSolution

Round 1: deposit 1,000; reserve 100; loan 900.
Round 2: deposit 900; reserve 90; loan 810.
Round 3: deposit 810; reserve 81; loan 729.
Total: deposits 10,000; reserves 1,000; loans 9,000.

Answer: Deposits 1,000 → 900 → 810 → ..., totalling ₹10,000; reserves total ₹1,000 (= initial deposit); loans total ₹9,000.

Example 4: Find the LRR · 3 marks · Short answerHarder board level

An initial deposit of ₹2,500 crore leads to total deposits of ₹12,500 crore. Calculate the money multiplier and the legal reserve ratio. (3 marks)

Try it first, then show the solutionSolution

Multiplier = 12,500 ÷ 2,500 = 5.
LRR = 1 ÷ 5 = 0.2 = 20%.
Check: 2,500 ÷ 0.2 = 12,500.

Answer: Money multiplier 5; LRR 20%.

Example 5: Find the initial deposit · 3 marks · Short answerHOTS / competency

Commercial banks created credit of ₹7,500 crore. The LRR is 25%. Calculate the initial deposit and total deposits. (3 marks)

Try it first, then show the solutionSolution

Multiplier = 4; credit = initial × (4 − 1) = 3 × initial.
Initial = 7,500 ÷ 3 = ₹2,500 crore.
Total deposits = 2,500 × 4 = ₹10,000 crore (check: 10,000 − 2,500 = 7,500).

Answer: Initial deposit ₹2,500 crore; total deposits ₹10,000 crore.

Example 6: Effect of a higher CRR · 1 mark · Assertion-reasonHOTS / competency

Assertion (A): An increase in the legal reserve ratio reduces the money-creating capacity of banks.
Reason (R): The money multiplier equals 1 ÷ LRR.
(a) Both A and R are true and R is the correct explanation of A.
(b) Both A and R are true but R is not the correct explanation of A.
(c) A is true but R is false.
(d) A is false but R is true.

Try it first, then show the solutionSolution

Higher LRR → smaller 1/LRR → less money created.

Answer: (a) Both A and R are true and R is the correct explanation of A.

Where students lose marks in Money Creation by Commercial Banks

The slips examiners see most often, and what to write instead.

Mistake: Treating total deposits as credit created
Forgetting to subtract the initial deposit.
Wrong working
Credit = ₹10,000 crore.
Right working
Credit = 10,000 − 2,000 = ₹8,000 crore.
Do this: Credit = total − initial.
Usually costs: 1 mark.
Mistake: Using the percentage instead of the fraction
1 ÷ 20 instead of 1 ÷ 0.2.
Wrong working
Multiplier = 1 ÷ 20 = 0.05.
Right working
Multiplier = 1 ÷ 0.20 = 5.
Do this: Convert % to a decimal first.
Usually costs: 1-2 marks.
Mistake: Not showing rounds when asked for the process
Writing only the formula.
Wrong working
Total = 1,000 × 10 = 10,000.
Right working
Show deposits, reserves and loans for three rounds, then totals.
Do this: 'Explain the process' = table.
Usually costs: 1-2 marks.

Exam tips

Credit creation appeared in about three tagged items (8 marks) in the PYQ bank; it is a reliable 3- or 4-mark numerical.
Write the multiplier formula first; it earns a step mark.
State the assumptions (all loans redeposited, LRR the only leakage) in 'explain' questions.

Practice questions on Money Creation by Commercial Banks

Write each answer on paper first. Open the hint only if you are stuck, and the answer only when you have finished.

Q1 · 1 mark · MCQBoard level
If the LRR is 10%, the money multiplier is:
(a) 1
(b) 10
(c) 100
(d) 0.1
Hint
1 ÷ 0.1.
Answer
(b) 10
Q2 · 1 mark · Short answerBoard level
Initial deposits are ₹500 crore and the LRR is 25%. Find total deposits. (1 mark)
Hint
× 4.
Answer
₹2,000 crore.
Q3 · 4 marks · Short answerBoard level
Explain the process of money creation by commercial banks. (4 marks)
Hint
Reserves, loans, redeposits, limit.
Answer
Banks keep a fraction (LRR) of deposits as reserves and lend the rest. Borrowers spend the loans; recipients redeposit them, creating new deposits, of which a fraction is kept and the rest lent again. Deposits grow in diminishing rounds until total reserves equal the initial deposit. Total deposits = initial deposit × 1 ÷ LRR; e.g. ₹100 with LRR 20% becomes ₹500, with ₹400 of loans.
Q4 · 3 marks · Short answerHarder board level
With an LRR of 12.5%, an initial deposit of ₹800 crore is made. Calculate total deposits and credit created. (3 marks)
Hint
Multiplier 8.
Answer
Multiplier = 1 ÷ 0.125 = 8; total deposits = 800 × 8 = ₹6,400 crore; credit = 6,400 − 800 = ₹5,600 crore.
Q5 · 3 marks · Short answerHarder board level
Prepare the final balance sheet of a bank that starts with a deposit of ₹100 when the LRR is 20%, after credit creation is complete. (3 marks)
Hint
Reserves 100; loans 400.
Answer
Assets: reserves ₹100, loans ₹400, total ₹500. Liabilities: deposits ₹500 (100 + 400), total ₹500.
Q6 · 2 marks · Short answerHarder board level
Total deposits of ₹1,00,000 crore were created from initial deposits of ₹5,000 crore. Find the LRR. (2 marks)
Hint
Multiplier = 20.
Answer
Multiplier = 1,00,000 ÷ 5,000 = 20; LRR = 1 ÷ 20 = 5%.
Q7 · 1 mark · Assertion-reasonHarder board level
Assertion (A): The credit creation process stops when total required reserves equal the initial deposit.
Reason (R): At that point, banks have no excess reserves to lend.
(a) Both A and R are true and R is the correct explanation of A.
(b) Both A and R are true but R is not the correct explanation of A.
(c) A is true but R is false.
(d) A is false but R is true.
Hint
Stop rule.
Answer
(a) Both A and R are true and R is the correct explanation of A.
Q8 · 2 marks · Short answerHarder board level
Define M1 as per the syllabus and calculate it if currency held by the public is ₹30 thousand crore and net demand deposits are ₹50 thousand crore (fictional figures). (2 marks)
Hint
Add the two.
Answer
M1 = currency held by the public + net demand deposits held by commercial banks = 30 + 50 = ₹80 thousand crore.
Q9 · 3 marks · Short answerHOTS / competency
Suppose borrowers keep part of their loans as cash at home instead of redepositing them. How would actual money creation compare with the 1 ÷ LRR formula? (3 marks)
Hint
Another leakage.
Answer
It would be smaller. The 1 ÷ LRR formula assumes all loans return to banks as deposits, so LRR is the only leakage. Cash kept outside banks is an extra leakage: less is redeposited and lent in each round, so total deposits and credit created fall short of the formula's value.
Q10 · 3 marks · Short answerHOTS / competency
Banks hold reserves of ₹250 crore. The RBI raises the legal reserve ratio from 10% to 12.5%. Explain what happens to the deposits and loans these reserves can support. (3 marks)
Hint
Multiplier 10 → 8.
Answer
At 10%, reserves of ₹250 crore support deposits of 250 ÷ 0.10 = ₹2,500 crore and loans of ₹2,250 crore. At 12.5%, they support deposits of only 250 ÷ 0.125 = ₹2,000 crore and loans of ₹1,750 crore. Banks must call back some loans to meet the higher reserve requirement, so money supply falls.

Test your recall

Answer in your head or on paper first, then open the card. Pulling an answer out of memory makes it stick far better than re-reading.

1.Formula for money multiplier?Show answer
1 ÷ LRR.
2.LRR 5%: multiplier?Show answer
20.
3.Initial deposit ₹200, LRR 20%: credit created?Show answer
₹800.
4.When does credit creation stop?Show answer
When total reserves equal the initial deposit.
5.What is the spread?Show answer
The difference between the lending rate and the deposit rate; the bank's profit.

Money Creation by Commercial Banks: frequently asked questions

How do commercial banks create money?

By keeping only a fraction of deposits as reserves and lending the rest; loans come back as new deposits and are lent again, so total deposits become a multiple of the initial deposit.

What is the money multiplier?

The ratio of total deposits to the initial deposit (or reserves): 1 ÷ LRR.

What limits credit creation?

The legal reserve ratio set by the RBI (CRR, with SLR also locking up funds); a higher ratio means less money creation.

How do you find the LRR from given deposits?

Divide total deposits by the initial deposit to get the multiplier, then LRR = 1 ÷ multiplier.