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6. (a) (i) Explain, using a numerical example, how banks create credit in an economy - Leaving Cert Economics - Question 6 - 2013
Question 6
6. (a) (i) Explain, using a numerical example, how banks create credit in an economy. (ii) Outline two factors which limit the ability of banks to create credit duri... show full transcript
Worked Solution & Example Answer:6. (a) (i) Explain, using a numerical example, how banks create credit in an economy - Leaving Cert Economics - Question 6 - 2013
Step 1
Explain, using a numerical example, how banks create credit in an economy.
Answer
Banks create credit through a process known as fractional reserve banking. When a bank receives deposits, it is required to hold a percentage in reserve and can lend out the remainder. For example, if a bank receives a deposit of €100 and the reserve requirement is 10%, it must keep €10 in reserve and can lend out €90.
This process can be illustrated numerically:
- Initial Deposit: €100
- Reserve Ratio: 10%
- Amount held in reserve: €100 x 10% = €10
- Amount available to lend: €100 - €10 = €90
Upon lending this €90, the borrower may deposit it into another bank, which in turn will again hold 10% in reserve and can lend out €81, thereby increasing the total credit in the economy. This chain reaction can multiply the initial deposit across the banking system, significantly increasing overall credit.
Thus, the total credit created from the initial €100 deposit can be calculated using the formula for the money multiplier:
ext{Credit} = rac{ ext{Initial Deposit}}{ ext{Reserve Ratio}}
For our example, the total credit created will be:
ext{Total Credit} = rac{€100}{0.1} = €1000
Hence, the bank can create a total of €900 additional credit beyond the initial deposit.
Step 2
Outline two factors which limit the ability of banks to create credit during recessionary times.
Answer
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Creditworthy customers / Increased risks for banks: In times of recession, banks are cautious in their lending practices because of increased risk associated with borrowers. Customers may have lost their jobs or income, leading banks to perceive them as higher-risk, thereby limiting the amount of credit extended.
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Demand for loans: Decreased demand for loans during recessions can also contribute to lower credit creation. Businesses and consumers may be hesitant to take on debt amidst economic uncertainty, causing banks to hold onto excess reserves rather than lending them out.
Step 3
Outline two possible economic effects of this measure for an economy.
Answer
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Increased bank lending: Quantitative easing typically injects liquidity into the economy, encouraging banks to lend more. This can boost consumer spending and encourage businesses to invest, thereby helping to stimulate economic growth.
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Economic growth / jobs: As banks increase their lending, consumer spending is likely to rise, leading to greater demand for goods and services. This increased demand can spur job creation, as businesses respond to the need for more workers to meet the heightened activity.
Step 4
Discuss two possible economic benefits of falling interest rates for the Irish economy.
Answer
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Borrowing encouraged: With lower interest rates, the cost of borrowing decreases. This can lead to increased consumer spending as loans become cheaper, fostering economic growth and improving living standards.
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Savings discouraged: Lower interest rates can also discourage saving, leading individuals to spend more of their money. Increased spending can stimulate the economy further, positively impacting retail and service sectors.