‘Reserve Ratio and Credit Creation are inversely related.’ Do you agree with the given statement? Justify your answer with a suitable numerical example.

Question 7:‘Reserve Ratio and Credit Creation are inversely related.’ Do you agree with the given statement? Justify your answer with a suitable numerical example.

The correct answer is – Yes, I agree with the given statement that Reserve Ratio and Credit Creation are inversely related. The reserve ratio is the portion of deposits that commercial banks are required to hold in reserve, while credit creation is the process by which commercial banks create credit by making loans to customers.

The relationship between reserve ratio and credit creation can be explained by the following example:

Let’s say that the Reserve Bank of India (RBI) sets the reserve ratio at 10%. This means that commercial banks are required to hold 10% of their deposits in reserve and can use the remaining 90% for lending to customers.

Assuming that the total deposits in the banking system are Rs. 1,000 crores, the commercial banks would be required to hold reserves of Rs. 100 crores (10% of total deposits) and can lend the remaining Rs. 900 crores.

If the RBI decides to increase the reserve ratio to 20%, the commercial banks would be required to hold reserves of Rs. 200 crores (20% of total deposits) and can lend only Rs. 800 crores. This means that the credit creation capacity of the commercial banks has been reduced.

On the other hand, if the RBI decides to decrease the reserve ratio to 5%, the commercial banks would be required to hold reserves of Rs. 50 crores (5% of total deposits) and can lend Rs. 950 crores. This means that the credit creation capacity of the commercial banks has been increased.

Thus, we can see that an increase in the reserve ratio reduces the credit creation capacity of the commercial banks, while a decrease in the reserve ratio increases the credit creation capacity. This is because a higher reserve ratio means that commercial banks have less money available for lending, while a lower reserve ratio means that they have more money available for lending. Therefore, we can conclude that the reserve ratio and credit creation are inversely related.