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Process of Credit Contrition

There will be multiple contraction of credit when cash is removed from the banking system. The process of credit contraction will be just the reverse of the process of crudity expansion. We can easily illustrate this with the help of a simple example.

Let us take the case of multiple-bank economy. We assume for the sake of simplicity that every bank has a cash reserve of Rs. 5,000, total deposits of Rs. 50,000 and loans and investments worth Rs. 45,000. We further assume the minimum ratio of cash to deposits is 10 per cent.

Suppose that a depositor withdraws Rs. 1,000 from Bank A. The balance sheet of Bank A will look as follows after the transaction:
Liabilities                                Assets
Deposits          49,000             Cash                               4,000
                                                 Loans and
                                                 Investments                     45,000 
                   Total 49,000                                           Total 49,000

Bank A has deposit liabilities of Rs. 49,000; it has got cash reserves valued at only Rs. 4,000, whereas for the given cash reserve ratio of 10%, it needs to have Rs. 4,900 in the form of cash. The bank will make up the deficiency by disposing of Rs, 900 worth of investments. Suppose, these investments are purchased by a person who is a customer of Bank A will receive Rs. 900 from Bank B. After the transaction, the balance sheet of Bank A will look as follows:

Liabilities                                 Assets 
 Deposits        49,000           Cash                                 4,900
                                                Loans and
                                                Investments                      44,100
             Total  49,000                                           Total   49,000

Bank A, it is clear from its balance sheet, has been able to restore itself to a satisfactory position by disposing of some investment. But in the process it has created difficulties for Bank B. Let us look at the balance sheet of Bank B after the transaction:
Liabilities                            Assets                      
Deposits          49,100        Cash                                      4,100
                                               Loans and
                                              Investments                        45,000
                  Total 49,100                                         Total  49,100         

It would be seen that Bank B is left with a cash reserve of only Rs. 4,100, whereas its deposit liabilities are worth Rs. 49, 100. Bank B, therefore, requires cash reserves worth Rs. 4,910. In other words, its cash reserves fall short by Rs. 810. It will make up this deficiency by selling its investments to the rune of Rs. 810. Suppose, these investments are purchased by a person who banks with Bank C. Bank  C will transfer cash reserves worth Rs. 810 to Bank B. After the transaction the balance sheet of Bank B will be as follows:

Liabilities                            Assets
Deposits         49,100        Cash                                        4,910
                                              Loans and
                                              Investments                            44,190
                 Total 49,100                                              Total 49,100

Bank B is in a position to restore itself to a satisfactory position. But in the process it has created difficulties for Bank C. The balance sheet of bank C will look as follows:

Liabilities                           Assets
Deposits          49,190       Cash                                           4,190
                                              Loans and
                                              Investments                              45,000
                  Total 49,190                                              Total   49,190

Now, Bank C has a deficiency of cash-against its requirements of Rs. 4,919, it has cash reserves value at only Rs. 4,190, i.e., its cash reserves fall short by Rs. 729. It will make goods this efficiency be selling its investments. And so it goes on till all the effects are fully exhausted. Thus, the original reduction of deposits by Rs. 1,000 from Bank A is followed by contraction in deposits of Rs. 900 by Bank B, of Rs. 810 by Bank C, and so on. Thus, it would be seen that the process of credit contraction is the as that of deposit expansion; the process of contraction moves in the reverse direction. When this process ends, we find that the deposits of banking institutions in the whole economy have been reduced by Rs. 10,000. In other words, the initial withdrawal of Rs. 1,000 in cash from the Bank A results into a contraction of credit worth Rs. 10,000 in the whole economy.

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