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 only €100 into the bank • The bank knows from experience that 10% of this money is ever demanded in cash.

• So if it keeps €10 in the bank it can lend out the other • They want more!!!

€90 (=10x9).

• Banks are not happy to do just this.

• If they keep the full lending €900 • Where does this €100 (= 100X9).

€900 cash in the bank then they can get away with come from?

• They generate €900 by allowing customers to open overdraft a/c’s.

• Customers then write lodged in the bank as cheques deposits .

.

• These cheques will eventually be

• The bank now has deposits of €1,000.

• But still only has demanded!

• No cash transactions. €100 cash which is all it needs as only 10% will be changes hands in these • 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 Total Deposits X 100 €100 €1,000 Reserve Ratio/PLR = 10 % X 100

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.

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 148 1. 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.