Money & Banking Chapter 17. 2008 Q 8 Explain with the aid of an example, how it is possible for banks to create credit.

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Presentation transcript:

Money & Banking Chapter 17

2008 Q 8 Explain with the aid of an example, how it is possible for banks to create credit.

Mr X lodges €100 into the bank The bank knows from experience that only 10% of this money is ever demanded in cash. So if it keeps €10 in the bank it can lend out the other €90 (=10x9). Banks are not happy to do just this. They want more!!!

If they keep the full €100 cash in the bank then they can get away with lending €900 (= 100X9). Where does this €900 come from? They generate €900 by allowing customers to open overdraft a/c’s. Customers then write cheques. These cheques will eventually be lodged in the bank as deposits.

The bank now has deposits of €1,000. But still only has €100 cash which is all it needs as only 10% will be demanded! No cash changes hands in these transactions. Credit has been created based on the Primary Liquidity Ratio (PLR).

Primary Liquidity Ratio The amount of loans a bank gives out is related to, but in excess of their cash deposits and is based on their reserve ratio. It is written as a percentage.

Formula Reserve Ratio/PLR = Cash X 100 Total Deposits €100 X 100 €1,000 Reserve Ratio/PLR = 10 %

Increase in the Money Supply (increase in cash reserves x 1 ) – inc in cash reserves reserve ratio ( €100 x 1 ) - € €900

Note The lower the PLR the more money the banks can create. The higher the PLR the less money the banks can create.

Balance Sheet of a Bank 1 Assets Cash lodged by Mr X €100 Total Assets €100 Liabilities Mr X’s Deposit €100 Total Liabilities €100

Balance Sheet of a Bank 2 Assets Cash lodged by Mr X €100 Loans €900 Total Assets €1,000 Liabilities Mr X’s Deposit €100 Deposits €900 Total Liabilities €1,000

Secondary Liquidity Ratio Is the ratio of liquid assets (easily turned into cash eg. shares) held by the banks to claims on the bank. PLR = Cash:Loans SLR = Cash & Liquid Assets: Loans

Measuring the Money Supply M 1 Is the notes & coins in circulation. Plus all balances in current a/c’s in all licenced banks in the state.

M 3 The Broad Money Supply Is the notes & coins in circulation. Plus all balances in current a/c’s in all licensed banks in the state. Plus balances in deposit a/c’s. Plus borrowings from other credit institutions. Less inter-bank balances.

Limits on the powers of banks to create credit P Availability of cash deposits: 2.Availability of creditworthy customers. 3.Customer’s demand for cash: 4.ECB guidelines & PLR

2002 Q 5 (b) Demand for cash falls. Therefore the bank can keep less cash reserves. Therefore banks can loan out more. People can spend more in shops. Shops can deposit more in banks.

2009 Q 5 (c) Motor Industry Decreased demand for cars. People have less chance of getting a loan so cannot buy a new or second hand cars…………

Sub-prime lenders

2008 A desire to reduce their level of bad debts will reduce the banks ability to create credit. They will hold more cash and lend out less. Not issuing loans means less credit is created.

2009 Q 4 (a) Banks may fail by overextending their loan book. Explain this statement within the context of a bank’s twin requirements of liquidity and profitability.