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IAI Actuarial Core Principles · Business Economics · Role, structure and stability of the financial system

Banks in an economy must hold reserves equal to 8% of deposits and hold no excess reserves. Customers hold no cash. The central bank injects Rs 200 crore of new reserves into the banking system through open market purchases of bonds from banks. What is the maximum eventual increase in deposits?

The maximum deposit expansion is Rs 2,500 crore. With an 8% reserve ratio the money multiplier is 1 divided by 0.08, or 12.5, and applying it to the Rs 200 crore of new reserves gives the total increase in deposits.

  1. ARs 1,600 crore
  2. BRs 2,500 croreCorrect
  3. CRs 2,300 crore
  4. DRs 16 crore
  5. Rs 200 crore

Explanation

The money multiplier is 1/0.08 = 12.5. The maximum increase in deposits is 200 x 12.5 = Rs 2,500 crore. Rs 1,600 crore wrongly multiplies by the reserve ratio's percentage figure of 8, and Rs 16 crore multiplies the reserves by 0.08.

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