Question

Assuming that banks choose to maintain a liquidity ratio of 20 per cent and assuming that new cash deposits of $100m are made in the banking system described in the table below:

	$m		$m
Banks receive	100	Hold Lend	20 80
Second round deposits rise by		Hold Lend
Third round deposits rise by		Hold Lend
Fourth round deposits rise by		Hold Lend
Fifth round deposits rise by		Hold Lend
Total deposits after five rounds

    (a)    Complete the above displayed table which shows how credit is created. (5 marks).

    (b)   How much credit will have been created after five rounds? (1 mark)…………………..

    (c)    To what level will total deposits eventually increase? (1 mark)………………………..

   

    (d)   Define the bank multiplier. (1 mark)…………………………………………………..

   

    (e)    What is the bank multiplier in this case? (1 mark)...........................................................

   

    (f)    How is it related to the liquidity ratio? (1 mark)..............................................................

Answer 1

A.

		$m
$m
Banks receive	100	Hold	20
		Lend	80
Second round deposits rise by	80	Hold	16
		Lend	64
Third round deposits rise by	64	Hold	12.80
		Lend	51.20
Fourth round deposits rise by	51.2	Hold	10.24
		Lend	40.96
Fifth round deposits rise by	40.96	Hold	8.19
		Lend	32.77
Total deposits after five rounds	336.16

B

Total credit created after five rounds = 80+64+51.2+40.96+32.77

Total credit created after five rounds = $268.93 M

C.

Total deposit increase = 100*(1/20%)

Total deposit increase = $500 M

D.

It refers to the number of times the money is created when $1 is deposited in the bank.

E.

Bank multiplier = 1/required reserve ratio = 1/20%

Bank multiplier = 5

F.

A higher multiplier, increase more money creation and it also increases the current assets. As a result, liquidity ratio increases.