Question

The Cash Reserve Ratio requirement imposed by the central bank is 3%.

1)Suppose Bank A receives a Rs. 5,000 deposit from a customer. Assuming that it wishes to hold no
excess reserve beyond the regulatory requirement, determine how much the bank is free to
lend (assuming no other restrictions). Show your answer on Bank A’s balance sheet.
Assume that the loan created by Bank A ends up as deposit in Bank B which in turn creates another loan.
Using the money multiplier, calculate the total change in the money supply that will finally result from continuation of the
above process of lending and deposit creation through the banking system

2)Consider the following scenarios and explain whether the money multiplier will increase, decrease or remain unchanged:
(a) banks decide to hold excess reserves with the central banks,
(b) more stores start accepting credit cards,
(c) people start keeping some part of the money in cash and only deposit the rest in banks.

Answer 1

1)

Cash Reserve Requirement = 3%

Deposits recieved = Rs. 5,000

Assuming that the bank does not wish to hold no excess reserve beyond the regulatory requirement, out of Rs. 5000 the bank can lend 4,850.

The bank is required to keep 3% of deposits as cash reserves, i.e. 3% of 5,000 = Rs.150. Hence, the bank can lend remaining Rs. 4,850.

The money multiplier = 1/ Cash Resetve ratio = 1/0.03 = 33.3%

Total change in Money supply = 5000*(1/0.03) = 1,66,666.67

2)

The size of the money multiplier is determined by the currency ratio (Cr) of the public, the required reserve ratio (RRr) at the central bank, and the excess reserve ratio (ERr) of commercial banks.

m = 1 + Cr/ CR+RRr+ERr

where m is money multiplier

a) If banks decide to hold excess reserves wth central bank, the cash reserve ratio (RRr) which is currently 3% will rise. As a result of this money multiplier will fall as now much of the deposits amount recieved by banks will not be used for loans instead will be kept with central banks as reserves.

b) If more stores start accepting credit cards, then demand of credit cards will increase. Credit card is a type of loan only because we pay for the amount billed out of credit card at a later point of time with interest. Hence, rising demand for credit cards will imply the demand for loans will rise. This means that banks will now keep less reserves and provide more loans, implying ERr will fall. As a result of this fall in ERr, money multiplier will rise.

c) If people start keeping some part of money in cash and deposit the rest in banks, then this means that currency ratio(CR) of public has increased. If CR falls, then as per the formula for money multiplier, both numerator and denominator has increased. Hence, money multiplier should not change. But when deposits reduce, baks lending caapcity reduces and Err rises, as a result of which money multiplier will fall.