Money and Banking — Practice

Question 1

Suppose the Cash Reserve Ratio (CRR) is 5% and someone deposits ₹2,000 in a bank. Calculate: (i) The total deposit that can be created in the banking system. (ii) The money multiplier.

Accepted Answer

(i) Money Multiplier = 1 / CRR = 1 / 0.05 = 20. Total deposits created = Initial Deposit × Money Multiplier = ₹2,000 × 20 = ₹40,000. (ii) Money Multiplier = 1 / CRR = 1 / 0.05 = 20. INTERPRETATION: An initial deposit of ₹2,000 can lead to ₹40,000 of total deposits through the banking system's process of lending and re-depositing — i.e., the banking system can create ₹38,000 of additional money from the initial ₹2,000 deposit.

Question 2

Explain how the RBI can use (a) the repo rate and (b) open market operations to control inflation.

Accepted Answer

CONTEXT — CONTROLLING INFLATION: Inflation means the general price level is rising, often because too much money is chasing too few goods. The RBI's goal is to REDUCE MONEY SUPPLY (contractionary monetary policy). (a) REPO RATE: The repo rate is the rate at which the RBI lends money to commercial banks. To control inflation, RBI INCREASES the repo rate. Effect: Commercial banks face HIGHER BORROWING COSTS from the RBI. They pass this on by RAISING LENDING RATES for consumers and firms. At higher interest rates: (1) Borrowing becomes MORE EXPENSIVE → households and firms take fewer loans. (2) Consumption and investment FALL. (3) This REDUCES Aggregate Demand → puts downward pressure on prices. Mechanism: ↑ Repo Rate → ↑ Bank Lending Rates → ↓ Borrowing → ↓ AD → ↓ Inflation. (b) OPEN MARKET OPERATIONS (OMO): The RBI SELLS government securities to commercial banks in the open market. Effect: Banks pay the RBI for these securities → money FLOWS OUT of banks and INTO the RBI → banks have LESS MONEY to lend. With less money available, banks must REDUCE lending → money supply CONTRACTS → AD falls → inflation is controlled. Mechanism: RBI sells securities → banks' reserves fall → lending capacity falls → money supply falls → AD falls → ↓ inflation. Both tools work through the SAME channel: reducing the money supply, which reduces aggregate demand, which controls inflation.

Question 3

Explain the process by which commercial banks create credit. What are the limitations of the credit creation process?

Accepted Answer

THE PROCESS OF CREDIT CREATION: Commercial banks create CREDIT (new deposits) through the process of lending and re-depositing. This is not magic — it is the LOGICAL CONSEQUENCE of banks keeping only a FRACTION of deposits in reserve. STEP-BY-STEP (with CRR = 10%): Suppose an initial deposit of ₹1,000 is made in Bank A. ROUND 1 — Bank A: Keeps ₹100 (10% CRR) with RBI. Lends ₹900 to a borrower. The borrower spends ₹900 on goods → the seller deposits ₹900 in Bank B. ROUND 2 — Bank B: Keeps ₹90 (10% of ₹900). Lends ₹810. The ₹810 is deposited in Bank C. ROUND 3 — Bank C: Keeps ₹81. Lends ₹729. The process continues infinitely, with each round creating smaller and smaller deposits. TOTAL DEPOSITS CREATED: Sum = ₹1,000 + ₹900 + ₹810 + ₹729 + ... = ₹1,000 × (1/0.10) = ₹1,000 × 10 = ₹10,000. Money Multiplier = 1/CRR = 1/0.10 = 10. Of the ₹10,000 total, ₹1,000 was the original deposit — the banks have CREATED ₹9,000 of NEW deposits through lending. HOW BANKS CREATE CREDIT: Note that banks do not physically print money — they create PURCHASING POWER by making loans that become deposits. A bank loan creates a deposit (asset for the borrower, liability for the bank) — which can then be lent again. WHY THE RBI CAN CONTROL THIS: By changing the CRR, the RBI changes the multiplier. CRR 10% → multiplier 10. CRR 20% → multiplier 5. Raising CRR reduces credit creation; lowering CRR increases it. LIMITATIONS OF THE CREDIT CREATION PROCESS: (1) CASH LEAKAGE: The model assumes ALL lent money is redeposited into the banking system. In reality, some people hold CASH — every ₹100 held as cash rather than deposited reduces the multiplier. (2) EXCESS RESERVES: Banks may choose to hold more than the minimum CRR (during recessions, banks become risk-averse and hold excess reserves rather than lending). This reduces the multiplier below the theoretical maximum. (3) DEMAND FOR LOANS: Credit creation requires willing BORROWERS. During a recession, even if banks are willing to lend, firms and consumers may not want to borrow (fear, low confidence). The RBI can make credit AVAILABLE (lower rates) but cannot FORCE banks to lend or people to borrow. (4) RBI CONTROLS: The CRR is set by the RBI — banks cannot exceed the maximum multiplier the CRR implies.

Practice — Money and Banking

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