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2281 · 3.1

Money and banking — practice questions

Practice and worked examples for 2281 Money and banking. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

A customer deposits $10,000 of new cash into the banking system. The required liquidity ratio (reserve ratio) is 20%. Assuming all loans are re-deposited and banks lend out all excess reserves, calculate the maximum potential increase in the total money supply.

Show solution outline

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

  • Initial New Deposit = 10,00010,000
  • Liquidity Ratio (LR) = 20% or 0.20

Step 2: Calculate the money multiplier.

  • The money multiplier determines the maximum 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).

  • The total increase is the initial deposit multiplied by the money multiplier.
  • Formula: Total Increase in Money Supply = Initial New Deposit × Money Multiplier
  • Calculation: 10,000×5=10,000 \times 5 = 50,000

Final Answer: The maximum potential increase in the total money supply (in the form of bank deposits) resulting from the initial cash deposit is **50,000∗∗.50,000**.

Worked example 2

A central bank cuts its policy rate from 4% to 2% when inflation is 1% and unemployment is above the NAIRU. Commercial banks pass on half the cut to borrowers.

Analyse the likely transmission mechanism to AD and evaluate risks to other macroeconomic objectives. [10 marks]

Show solution outline

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.

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