Money and banking — practice questions

This problem demonstrates the credit creation process using the money multiplier.

Step 1: Identify the initial deposit and the liquidity ratio.

• Initial Deposit (New Reserves) = $10,000
• Liquidity Ratio (LR) = 20% or 0.20

Step 2: Calculate the money multiplier. The money multiplier shows the maximum potential expansion of the money supply from a new deposit.

• Formula: Money Multiplier = 1 / Liquidity Ratio
• Calculation: Money Multiplier = 1 / 0.20 = 5

Step 3: Calculate the total increase in the money supply (deposits). This is the initial deposit multiplied by the money multiplier.

• Formula: Total Increase in Deposits = Initial Deposit × Money Multiplier
• Calculation: Total Increase in Deposits = $10,000 × 5 = $50,000

Step 4: Calculate the total amount of new credit created (loans). The total credit created is the total increase in deposits minus the initial cash deposit that started the process.

• Formula: Total Credit Created = Total Increase in Deposits - Initial Deposit
• Calculation: Total Credit Created = $50,000 - $10,000 = $40,000

Summary of the process:

• The initial $10,000 deposit increases the money supply by $10,000.
• The banking system then creates an additional $40,000 in loans, which become new deposits.

Final Answer: The maximum total increase in the money supply resulting from the initial $10,000 deposit is $50,000.

Transmission to AD:

1. Effective lending rate falls by ~1 percentage point (half pass-through) → cheaper mortgages and business loans.
2. Consumption: lower debt service → ↑ disposable income → C rises.
3. Investment: lower cost of capital → I rises (especially interest-sensitive sectors).
4. Exchange rate: lower rates → capital outflows → currency depreciates → exports cheaper, imports dearer → (X − M) improves.
5. Combined effect: AD shifts right → output and employment rise toward NAIRU.

Risks to other objectives:

• Inflation: with inflation already low at 1%, AD stimulus may be appropriate short run; if economy nears capacity, demand-pull inflation returns.
• Asset prices: lower rates may inflate house and stock prices - financial stability risk, worsens wealth inequality.
• BOP: depreciation helps X but import prices rise - cost-push pressure on inflation.
• Incomplete pass-through: if banks hoard margins, transmission weakened - policy less effective.

Judgement: Cut is justified given unemployment above NAIRU and low inflation, but central bank must monitor asset bubbles and inflation expectations.