Money & BankingMoney & BankingMoney & BankingMoney & Banking

2008 Q 8 (a) • Explain with the aid of an

example, how it is possible for banks to create credit.

http://www.youtube.com/watch?v=qu2uJWSZkck

• 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.

2008 Q (a)

• A desire to reduce a banks level of bad debts will reduce their ability to create credit.

• They will hold more cash and lend out less.

• Not issuing loans means less credit is created.

Limits on the powers of banks to create credit

2008 Q 8 (a) (iii)

1. Availability of cash deposits:2. Availability of creditworthy

customers.3. Customer’s demand for cash:4. ECB guidelines & PLR

Students: write a brief not on each.

• 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 €1,000Reserve Ratio/PLR = 10 %

Increase in the Money Supply

(increase in cash reserves x 1 ) – inc in cash reserves

reserve ratio

( €100 x 1 ) - €100 .10

€900

Note• The lower the PLR the more

money the banks can create.

• The higher the PLR the less money the banks can create.

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.

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.

• 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.

2002 Q 5 (b)

Sub-prime lenders• Financial institutions that loan

money to borrowers who have low income or bad credit rating at a higher rate of interest.