What Is Contraction Of Credit And What Are The Limits Of The Credit Creation?

Just as deposits create loans and loans create deposits, similarly the withdrawal of deposits contracts credit. For example if cash reserve ratio is 20 percent the initial reduction of rupees 1000 in bank A will lead to a reduction of deposits of rupees 800 in bank B, of rupees 640 in bank C and so on. If this process of credit contraction is continued the total deposits in the banking system is reduced by rupees 5000.

The capacity of the bank to create credit is subject to certain limitations. First of all is cash drain. In the chain process of multiple expansion and contraction of credit, it is assumed that all payments are made by cheques and not in cash. In case some borrowers or most of the borrowers withdraw a part or the entire amount loaded to them in cash, banks will not be able to create credit to the desired extent. An outflow of cash from the reserves of the banks will reduce their ability to expand deposits and vice versa.

The next is the transfer of deposits to non bank financial institutions. The transfer of funds to non bank financial institutions can also limit the credit creation ability of the banks.