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Explain, with the aid of an example, how it is possible for banks to create credit - Leaving Cert Economics - Question 8(a) - 2008
Question 8(a)
Explain, with the aid of an example, how it is possible for banks to create credit. Outline how a desire by banks to reduce their level of bad debts might affect th... show full transcript
Worked Solution & Example Answer:Explain, with the aid of an example, how it is possible for banks to create credit - Leaving Cert Economics - Question 8(a) - 2008
Step 1
Explain, with the aid of an example, how it is possible for banks to create credit.
Answer
Banks are able to create credit through a process known as fractional reserve banking. For example, if a customer deposits €100 in a bank, the bank can lend out a portion of that deposit while retaining a fraction as reserves.
Assuming the bank's reserve requirement is 10%, it must keep €10 as reserves and can lend out €90. This loan can then be deposited into another bank, which can repeat the process. Therefore, the original deposit of €100 leads to an increase in credit of up to €900 through subsequent lending, calculated by the formula:
In this case, the bank can create credit based on the fraction of deposits not demanded in cash.
Step 2
Outline how a desire by banks to reduce their level of bad debts might affect their ability to create credit.
Answer
When banks aim to reduce bad debts, they tend to adopt a more cautious approach towards lending. This means they may impose stricter credit assessments and limit the amount of lending to potential borrowers. Consequently, their overall lending capacity may diminish, resulting in a reduced ability to create new credit. If banks are less willing to issue loans, the flow of credit in the economy can contract.
Step 3
Explain two other factors which could affect their ability to create credit.
Answer
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Availability of Cash Deposits: A bank can only create loans equivalent to the deposits it attracts. If cash deposits are low, the bank cannot lend as much, limiting its credit creation.
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Customers’ Demands for Cash: If customers demand a greater percentage of their deposits in cash, banks will need to retain more cash reserves to meet these demands and therefore will have less available for lending. This can also restrict their ability to create credit.