Explain, using a numerical example, how an increase in reserve deposit

ratio affects the credit creation power of the banking system.

Reserve deposit ratio is the percentage of deposits that the commercial banks are required to keep as cash according to the directions of the central bank (RBI).

a. Credit creation gives power to the banks to expand or contract demand deposits through the process of more loans, advances, and investments.

b. Whatever credit is lent out by the banks it comes to the bank as deposits, which is then again lent out and henceforth. The deposits are given out in the form of loans which again returns as deposits.

c. Banks cannot credit as per their wish because the amount of credit that a system of banking can create depends upon the reserve ratio. The higher is the reserve ratio, the smaller is the credit creation multiplier.

d. Credit creation multiplier=> 1/1-(1-reserve ratio) = 1/reserve ratio

Example: Deposit=Rs1000 Credit =Rs5000

Credit creation multiplier=5000/1000=5

Reserve ratio=1/5