Economics Essay

311 Words2 Pages
As we have seen, bank deposits of one form or another constitute by far the largest component of (broad) money supply. To understand how money supply expands and contracts, and how it can be controlled. It is thus necessary to understand what determines the size of bank deposits. Banks can themselves expand the amount of bank deposits, and hence the money supply, by a process known as ‘credit creation’ To illustrate the process of credit creation in its simplest form, the following assumptions are made: Banks have just one type of liability i.e. deposits And two types assets which are: {text:list-item} {text:list-item} Assume initially that the combined balance sheet of the banks is as shown in the table below: Now assume that the government spends more money-Rs 10 billion, say, on roads or the National Health Service. It pays for this with cheques drawn on its account with the Central Bank. The people receiving the cheques deposit them in their banks. Banks return these cheques to the Central Bank and their balances correspondingly increase by Rs 10 billion. The combined banks’ balance sheet now is: But this not the end of the story. Banks now have surplus liquidity. With their balances in the central bank having increased to Rs 20 billion, they now have a liquidity ratio of 20/110. If they are to return to a 10 % liquidity ratio, they need only retain Rs 11 billion as balances at the Central Bank ( Rs 11 billion/ Rs110 billion = 10%). The remaining Rs 9 billion they can lend to customers. Assume now that customers spend this Rs 9 billion in shops and the shopkeepers deposit the cheques in their bank accounts when the cheques are cleared, the balances in the Central Bank of the customers’ banks will duly be deposited by Rs 9 billion, but

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