Banks create money

The Reserve Bank of India (RBI), set up in 1935, is India's central bank. It issues currency, controls the money supply, acts as banker to the government and banker to the banks, and keeps the country's foreign exchange reserves.

Commercial banks take deposits and give loans. They pay a lower interest on deposits than they charge on loans; the spread between the two is their profit.

How can banks lend out deposits that people may want back? The book tells the story of Lala, a goldsmith who kept people's gold safely. He noticed that not everyone came for their gold at once, so he could lend some of it out. Banks work the same way: not all depositors withdraw at once, so banks keep only a part as reserves and lend the rest. And the loans come back into banks as new deposits, which can be lent again.

A bank's balance sheet: assets = reserves + loans; liabilities = mainly deposits; net worth = assets − liabilities.

This is how banks create money. The RBI fixes the cash reserve ratio (CRR): the fraction of deposits banks must keep as reserves. The money multiplier = 1 ÷ CRR. With a CRR of 10%, the multiplier is 1 ÷ 0.1 = 10, so ₹200 of reserves can support ₹2,000 of deposits, of which ₹1,800 are loans. A higher CRR means a smaller multiplier. Because of the reserve rule, banks cannot create unlimited money.