Question

Suppose Never Bank (not the central bank), operating in (fictitious country) Neverland holds $100 million in deposits. Also assume that banks in Neverland are supposed to maintain the (required) reserve ratio of 10%.

1. Assume initially that Never Bank is the only bank in Neverland. State the effects on money supply if Never Bank decides not to make any loans. Compare this to the effect on money supply if, alternatively, Never Bank decides to loan out all its available deposits for loans. (compare both the scenarios in 150 words or less).
2. What will be the effect on money supply if many banks start to open and operate in Neverland and they loan out all their available deposits. (explain in 100 words or less)
3. Go back to the scenario presented in Part a, where Never Bank is the only bank in Neverland. Suppose, people of Neverland decide to withdraw their deposits with the Never Bank and keep their money with them as currency. What is the quantity of money in Neverland in this situation? State the assumption you made here. Compare the quantity of money in this situation with the one in ‘Part a’ where the Never Bank does not make any loans out of its deposits. (answer each in 50 words or less)

Answer 1

Answer to Q.(a)

To increase or decrease in money supply in the economy central bank use several method and such moethod are called Monetary policy. If Neverland bank decided not to make any loans which means businesses will have limited access of money because businesses run on credit. It will have multiplier effect on the economy beacuse less money leads to a constrain in the supply of goods or services or both and that makes less growth in GDP.

However, if the bank start lending then credit lines will increase and overall business along with economy increase but risk of dafult also increase if loan given without proper scrutiny.

Answer to Q.(b)

If many bank stated lending money then supply of money will increase drastically.Such supply of money will have increase in GDP of the country in terms of higher consumption and capital investment but availability of money at lower interest cost will also leads to rise in inflation. Demand in money will kick in through such supply.

Answer to Q.(c)

If all money circulated in hand of public then liquidity in system may gets impacted. Currency in circulation will not generate value out it as it small ticket size and not easily available of business.