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Questions and Answers
What is the primary function of the required reserve ratio (CRR) set by the Central Bank?
If a bank has a cash reserve ratio (CRR) of 20% and receives a deposit of Rs 200, how much must be kept as reserves?
What is the result of Mr. Mathew depositing his loan amount back into the bank?
What does the Statutory Liquidity Ratio (SLR) require banks to maintain in addition to the CRR?
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In the context of monetary policy, why is there a limit on credit creation by banks?
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What might happen if a bank does not adhere to the reserve ratio requirements?
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Which term describes the concept where banks can only lend a portion of their deposits?
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How might the reserve ratio impact a bank's ability to generate loans?
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In what scenario can total money supply in the banking system continue to rise?
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How does the Central Bank (RBI) influence the economy through the reserve ratios?
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Study Notes
Banking and Money Creation Process
- The bank initially holds Rs 100 and is required to keep 20% as cash reserves, equating to Rs 20.
- After lending Rs 80 to Jaspal Kaur, total deposits increase to Rs 180.
- From Rs 180 deposits, the bank must maintain Rs 36 as reserves, allowing Rs 64 to be lent out again.
- The next borrower, Junaid, receives Rs 64, which gets added to total deposits.
- This lending process continues, ultimately requiring Rs 100 in reserves for total deposits to reach Rs 500.
- Total deposits of Rs 500 necessitate cash reserves of Rs 100 (20% of Rs 500), permitting Rs 400 in loans.
Money Multiplier Effect
- Each round of deposits increases the liability to the bank, illustrating the money creation capacity.
- With a cash reserve of Rs 100, the bank can support deposits up to Rs 500, creating loans of Rs 400.
- The money multiplier effect shows that reserves of Rs 100 can multiply to create deposits of Rs 500.
Reserve Requirements
- The Required Reserve Ratio (CRR) dictates the percentage of deposits banks must keep as reserves to control lending and prevent over-lending.
- For example, with a CRR of 20%, on deposits of Rs 100, banks must hold Rs 20 as reserves and can lend Rs 80.
- Banks are also obliged to maintain short-term liquid reserves through the Statutory Liquidity Ratio (SLR).
Central Bank's Role
- The Reserve Bank of India (RBI) is responsible for issuing currency and regulating the money supply in the economy.
- The RBI acts as a lender of last resort, providing funds to commercial banks when necessary, influencing overall credit creation.
- The central bank establishes regulations such as CRR to prevent excessive money supply and ensure economic stability.
Summary of Balance Sheet Insights
- The balance sheet comprises assets (reserves and loans) and liabilities (deposits) balanced at Rs 500.
- Reserves of Rs 100 can support total deposits of Rs 500 when following the mandated reserve ratio.
Implications for Monetary Policy
- The banking system can create credit based on reserve requirements, promoting economic growth while ensuring financial stability.
- The dynamic relationship between reserves, deposits, and loans illustrates the critical role of the central bank in managing the economy's money supply.
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Description
This quiz explains the money creation process in banking, including cash reserves and lending. Calculate the total deposits and required reserves in a series of lending transactions.
