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
€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
Total Liabilities
€100
€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
Deposits
Total Liabilities
€100
€900
€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
M1
• 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.