Explain two ways in which commercial banks create credit in the economy. For each way, give a brief example illustrating the process.
Answer
Banks create credit by (i) extending loans against deposits (e.g., a farmer’s loan) and (ii) discounting commercial bills (e.g., a trader’s bill of exchange).
Step-by-step solution
- State the first method: granting advances/loans to borrowers using the deposits they hold as a basis.
- Provide an example: a farmer approaches the bank for a loan to buy seeds; the bank creates a new deposit in the farmer’s account, thereby creating credit.
- State the second method: discounting bills of exchange or other negotiable instruments.
- Provide an example: a textile trader submits a bill of exchange payable in 90 days; the bank purchases the bill at a discount, crediting the trader’s account immediately.
- Explain that both processes increase the total deposits in the banking system, which expands the money supply.
Common mistake: Mentioning only loan creation and overlooking other credit‑creation mechanisms such as bill discounting.
Concept tested: Credit creation by banks
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