Question

Option 1: Evaluate the following statement: "Since any bank can only lend out its excess reserves, an increase in the monetary base that provides banks with excess reserves leads to a dollar for dollar increase in the money supply through bank lending." Option 2: Evaluate the following statement: "Banks must walk a tightrope between liquidity and profitability because the prudent policies such as holding lots of reserves that maintain liquidity reduce profitability." Option 3: In what way is it true that "banks make money by making money"

Answer 1

Answer with Explanation:

Option 1: "Since any bank can only lend out its excess reserves, an increase in the monetary base that provides banks with excess reserves leads to a dollar for dollar increase in the money supply through bank lending.- True

Reason:

Banks lend out its excess reserves after maintaining certain ratio as a part of legal reserve ratio predetermined by the Central bank. They maintain that percentage of their net deposits with the central bank.

If there is increase in monetary base , it means banks are getting more public deposits and legal reserve ratio is already fixed by the Central bank.

So, bank will left with excess reserves which it will lend and which leads to dollar for dollar by getting interest on its excess reserves.

Money supply will get increase as public are getting loan through bank lending.

Option 2: "Banks must walk a tightrope between liquidity and profitability because the prudent policies such as holding lots of reserves that maintain liquidity reduce profitability." - True

Reason:

When bank holds lots of reserves with itself to maintain the liquidity instead of lending it to the public, it will reduce its profitability.

As bank earn profits in the form of interest they getting while lending loans to public but if they hold it to itself they would not get any interest which will hamper their profitability.

Option 3: In what way is it true that "banks make money by making money"

Banks make money by making money.

Suppose banks gets a deposit of Rs.1000 as public deposit. Then after maintaining the legal reserve ratio says CRR i.e. 3% and SLR i.e. 18%.

So, After maintaining 21% reserve as LRR, remaining amount i.e. Rs.790 will be lent by banks to public as a loan with some rate of interest says 5%, he will get Rs. 829.50 in return .

So, bank made money by making money.