## Objective Questions with Problem-Solving on Bank Credit Creation:

**1. Which of the following BEST describes the process of bank credit creation?**

(a) Banks print new money based on loan demand.

(b) Banks lend a portion of their customers' deposits.

(c) Banks transfer money from government accounts to private accounts.

(d) Banks borrow money from the central bank and lend it out.

**Answer:** (b) Banks lend a portion of their customers' deposits.

**2. What is the main factor limiting the amount of credit a bank can create?**

(a) Interest rates

(b) Bank fees

(c) Capital adequacy ratio

(d) Cash reserve ratio

**Answer:** (d) Cash reserve ratio (CRR)

**3. If a bank has a CRR of 10% and receives a deposit of $100, how much can it potentially lend out?**

(a) $0

(b) $10

(c) $90

(d) $100

**Answer:** (c) $90. The bank keeps $10 (10% of $100) as reserves and can lend out the remaining $90.

**4. Which of the following actions by the central bank will decrease the money supply in the economy?**

(a) Lowering the CRR

(b) Increasing the interest rate

(c) Buying government bonds

(d) Selling government bonds

**Answer:** (d) Selling government bonds. This action removes money from circulation.

**5. What are the potential benefits and drawbacks of bank credit creation?**

(a) Benefits: increased economic activity, drawbacks: inflation

(b) Benefits: lower interest rates, drawbacks: financial crises

(c) Benefits: increased government revenue, drawbacks: higher taxes

(d) Benefits: improved personal wealth, drawbacks: increased poverty

**Answer:** (a) Benefits: increased economic activity, drawbacks: inflation

**6. Explain the concept of the "money multiplier" and how it relates to bank credit creation.**

**Answer:** The money multiplier is the factor by which the initial deposit can be multiplied to determine the potential total amount of credit created. It is calculated as 1/CRR.

* 1:**

A bank receives a deposit of $10,000 and has a Cash Reserve Ratio (CRR) of 10%.

**(a) Calculate the maximum amount the bank can lend.**

**(b) If the bank lends out 80% of the maximum amount, how much new money is created in the economy?**

**(c) Explain how this impacts the money supply and potential economic outcomes.**

**Answer:**

(a) Maximum lendable amount = Deposit * (1 - CRR) = $10,000 * (1 - 0.1) = $9,000.

(b) Money created = Loan amount = Maximum lendable amount * Lending rate = $9,000 * 0.8 = $7,200.

(c) This increases the money supply by $7,200. This can stimulate economic activity through increased spending and investment, but also potentially lead to inflation if not managed properly.

 2

The central bank increases the CRR from 5% to 10%.

**(a) How does this affect the bank's credit creation capacity?**

**(b) Explain the impact on the money supply and potential economic consequences.**

**(c) What tools can the central bank use to manage the money supply in response to this change?**

**Answer:**

(a) The credit creation capacity decreases as the bank can lend less due to a higher CRR requirement.

(b) The money supply growth rate slows down. This can potentially dampen inflation but also impact economic growth if excessive.

(c) The central bank can use open market operations (buying/selling government securities), adjusting discount rate (interest rate charged to banks), and changing reserve requirements to influence the money supply.

Explain how fractional reserve banking and the money multiplier amplify the impact of changes in the CRR on the money supply.

Answer:

With fractional reserve banking, banks only keep a portion of deposits as reserves, lending out the rest. This creates new deposits, and the process repeats, expanding the money supply based on a single initial deposit. The money multiplier amplifies this effect, showing the maximum potential increase in the money supply based on the CRR and lending rate. Changes in the CRR directly affect the multiplier, significantly impacting overall money creation.

Keynes's Multiplier 

**1. The Keynesian multiplier primarily focuses on understanding:**

(a) The relationship between inflation and unemployment in the long run.

(b) The impact of government spending on aggregate demand in the short run.

(c) The optimal level of government debt for economic growth.

(d) The efficiency of resource allocation in a perfectly competitive market.

**Answer:** (b) The impact of government spending on aggregate demand in the short run.

**2. The magnitude of the Keynesian multiplier primarily depends on:**

(a) The prevailing interest rate in the economy.

(b) The marginal propensity to consume (MPC) of households.

(c) The level of government debt accumulated over time.

(d) The trade balance and openness of the economy.

**Answer:** (b) The marginal propensity to consume (MPC) of households.

**3. Given a marginal propensity to save (MPS) of 0.3, the value of the Keynesian multiplier would be:**

(a) 0.3.

(b) 3.33.

(c) 0.7.

(d) 1.0.

**Answer:** (c) 0.7 (Multiplier = 1 / MPS)

**4. Suppose the government injects $1 billion into the economy through increased infrastructure spending, and the MPS is 0.2. What is the estimated total increase in aggregate demand according to the multiplier?**

(a) $1 billion.

(b) $2 billion.

(c) $0.5 billion.

(d) $5 billion.

**Answer:** (d) $5 billion (Multiplier * Government Spending = 1/0.2 * $1 billion)

**5. Which of the following is NOT a valid criticism of the Keynesian multiplier in real-world applications?**

(a) It assumes a closed economy with no international trade.

(b) It neglects potential time lags between spending injections and their impact on demand.

(c) It ignores potential crowding-out effects on private investment or government tax revenue.

(d) It assumes a perfectly elastic aggregate supply curve.

**Answer:** (d) It assumes a perfectly elastic aggregate supply curve.