Assuming that banks choose to maintain a liquidity ratio of 20 per cent and assu
ID: 1213561 • Letter: A
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:
(a) Complete the following table which shows how credit is created.
Total deposits afters five rounds
(b) How much credit will have been created after five rounds?
(c) To what level will total deposits eventually increase?
(d) Define the bank multiplier
(e) What is the bank multiplier in this case?
(f) How is it related to the liquidity ratio?
in million in million Banks receive 100 Hold 20 Lend 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 afters five rounds
(b) How much credit will have been created after five rounds?
(c) To what level will total deposits eventually increase?
(d) Define the bank multiplier
(e) What is the bank multiplier in this case?
(f) How is it related to the liquidity ratio?
Explanation / Answer
Total deposits after 5 rounds = $336.16 millions
Total credit created after 5 rounds = $268.92 millions
Money Mulitplier = 1 / Required reserve ratio.
Given that the required reserve ratio is 20%. Therefore, money multiplier = 1/0.2 = 5
Eventually, the total deposits will increase to 5 times the orignial deposit i.e. 5*100 = $500 million
The higher the money multiplier, the higher is the liquidity ratio and vice versa
Particulars Amount in Millions Particulars Amount in Millions Banks receive 100 Hold 20 Lend 80 Second round deposits rise by 80 Hold 16 Lend 64 Third round deposits rise by 64 Hold 12.8 Lend 51.2 Fourth round deposits rise by 51.2 Hold 10.24 Lend 40.96 Fifth round deposits rise by 40.96 Hold 8.192 Lend 32.768