Question

Banks are an important part of Australia’s financial system and their business includes taking deposits from the public and providing loans to households and businesses. What is a reserve ratio and explain how a fractional banking system operates? Following the 2008 global financial crisis (GFC), the real-world deposit multiplier tended to be way smaller than the simple multiplier. Explain why that was the case and how it would have affected the money supply in the economy.

Answer 1

The Bank system is responsible for creating the credit through the deposits. The initial deposits tend to create a multiple times rise in the money supply.

The reserve ratio is the percentage of deposits that kept as the reserve for meeting any kind of crisis. The rise in the reserve ratio leads to a decline in the lending capacities of banks.

the fractional reserve system is responsible for the credit creation. Under this system, banks are supposed to keep a certain part of deposits as the reserve and lend out the rest of the amount for earning interest. In this way, banks create multiple accounts and keep a certain part of each deposit as the reserve. The money supply is larger than the initial deposits received.

During the financial crisis, banks are not ready to lend out the full amount. They maintain the larger extra reserve so that any upcoming crisis can be averted easily. Thus money multiplier value does fall.