Exercises: Credit Creation and the Money Market

A commercial bank receives a deposit of €10,000 and must hold a required reserve ratio of 10%.

1. a) Calculate the reserves the bank must keep.

1. b) Calculate the maximum amount the bank can lend out from this deposit.

1. c) Explain why banks do not keep all deposits as cash.

Calculate the money multiplier when the reserve ratio is:

1. a) 10%

1. b) 20%

1. c) 5%

1. d) Explain what happens to the multiplier as the reserve ratio rises.

Name the main role of each of the following in the Irish financial system:

1. a) Central Bank of Ireland

1. b) The European Central Bank

1. c) Commercial banks

1. d) Credit unions

A new cash deposit of €50,000 is made in a bank in Sligo. The reserve ratio is 8%. Assume that all loans are re-deposited in the banking system and no cash is held outside banks.

1. a) Calculate the maximum total increase in deposits.

1. b) Calculate the total amount of new loans created.

1. c) Explain two reasons why the actual increase would be smaller than your result.

In a money market the demand for money is shown below at different interest rates, with the supply fixed by the central bank at €500 million.

Interest rate (%)	Money demanded (€m)
1	700
2	600
3	500
4	400
5	300

1. a) Identify the equilibrium interest rate.

1. b) Describe what happens at an interest rate of 2% and explain how the market adjusts.

1. c) The central bank raises the supply of money to €600 million. State the new equilibrium rate and explain the effect on borrowing and spending.

A bank has deposits of €400 million, reserves of €60 million and loans of €340 million.

1. a) Calculate the actual reserve ratio.

1. b) If the required reserve ratio is 10%, calculate the excess reserves and the potential additional lending by this bank alone.

1. c) Explain why a bank might choose to hold more reserves than required.

Irish banks expanded credit rapidly, particularly for property loans, in the years before 2008.

1. a) Explain how credit creation increases the money supply and the possible effects on property prices and inflation.

1. b) Explain how a fall in asset prices could reduce banks' capital and lending, with consequences for the wider economy.

1. c) Discuss the role of the Central Bank of Ireland and of the ECB in regulating banks and the money supply, including capital requirements and mortgage lending rules.

1. d) Evaluate whether stricter regulation could have prevented the crisis.

The reserve ratio is 12.5%. The banking system receives an injection of €80 million of new reserves from the central bank.

1. a) Calculate the money multiplier and the maximum increase in deposits.

1. b) If the public holds 20% of any new money as cash outside the banks and banks hold 12.5% as reserves, calculate the revised multiplier using $\frac{1}{r + c - rc}$ where $r$ is the reserve ratio and $c$ is the cash ratio, and the resulting increase in money supply.

1. c) Explain why central banks cannot control the money supply exactly.

1. d) Discuss how the ECB's interest rate decisions affect Irish credit conditions.

The demand for money in an economy is $M_d = 1,000 - 100i$ where $i$ is the interest rate in per cent and $M_d$ is in €million. The supply is fixed at €600 million.

1. a) Calculate the equilibrium interest rate.

1. b) The central bank reduces supply to €500 million. Calculate the new equilibrium rate.

1. c) Explain the effect of this change on investment, consumption and aggregate demand.

1. d) Discuss why a small euro area economy like Ireland cannot set its own interest rate and the implications for stabilising its economy.