Question

a) According to the Bank of England, money is created when a bank makes a loan and destroyed with the loan is repaid. Explain this statement. [8 marks]

b)Distinguish precisely between the real exchange rate and the nominal exchange rate. [8 marks]

Answer 1

a). We know that when a bank makes loan to a person , it simply creates money.  In other words, When the loan is made, it increases the money supply. This is how banks “create” money and increase the money supply. When a bank makes loans out of excess reserves, the money supply increases. Some banks hold excess reserves, customers withdraw cash, and some loan proceeds are not spent. ... And just as money is created when banks issue loans, it is destroyed as the loans are repaid. A loan payment reduces checkable deposits; it thus reduces the money supply.

When bank makes a loan to a person, the person uses this money to buy certain goods or services from it. This will increase the money suppply in the economy. Banks accept depositors’ money and lend it to borrowers. With the interest they earn on their loans, banks are able to pay interest to their depositors, cover their own operating costs, and earn a profit, all the while maintaining the ability of the original depositors to spend the funds when they desire to do so. One key characteristic of banks is that they offer their customers the opportunity to open checking accounts, thus creating checkable deposits. These functions define a bank, which is a financial intermediary that accepts deposits, makes loans, and offers checking accounts. The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected—to companies seeking to expand their operations, to people buying cars or homes, and so on.

KIndly find attachment for part (b).