Using a suitable numerical example, explain the credit creation process of the banking system, in a hypothetical economy.

The process of money creation is based on the assumptions that: When a commercial bank receives initial/primary deposits (say ₹ $\displaystyle 1,000$), as per the requirement of the Central Bank, it has to maintain some reserves. The remaining amount is made available for loans. The lent sum of money is received back in the next round of deposits as secondary deposits. This process of deposit, reserve and lending continues till initial deposits become equal to the sum total of reserves.

Round	Deposits	Loans	Reserves ($\displaystyle 20$%)
$\displaystyle 1$	$\displaystyle 1000$	$\displaystyle 800$	$\displaystyle 200$
$\displaystyle 2$	$\displaystyle 800$	$\displaystyle 640$	$\displaystyle 160$
$\displaystyle 3$	$\displaystyle 640$	$\displaystyle 512$	$\displaystyle 128$
…	…	…	…
…	…	…	…
Total	$\displaystyle 5000$	$\displaystyle 4000$	$\displaystyle 1000$

Total deposit creation = Initial deposits × $\displaystyle \frac{1}{Reserve\ Ratio}$= $\displaystyle 1000$ × $\displaystyle \frac{1}{0.2}$= ₹ $\displaystyle 5,000$Hence, total deposits of ₹ $\displaystyle 5000$ are created.