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Economics · 2023 · 4 marks
CBSE 2023 · Region 1 · Set 2 · Q14
Explain the ‘Government’s Bank’ function of the central bank.Using a hypothetical numerical example, explain the effect of rise in Reserve Ratio on credit creation by the commercial banks.
Explain the ‘Government’s Bank’ function of the central bank.
Using a hypothetical numerical example, explain the effect of rise in Reserve Ratio on credit creation by the commercial banks.
Marking-scheme solution
The central bank acts as a banker to the Government. It maintains the banking accounts of the government for the purpose of receiving/making payments on its behalf. It provides loans to the government, as per its requirements. The central bank also purchases/ sells government securities in the open market on behalf of the government.
Reserve ratio (RR) is the minimum reserves that a commercial bank must maintain as per the directions of the central bank. Credit creation is inversely related to the reserve ratio.
Example: Suppose the initial deposit is ₹$\displaystyle 1000$
| Case | Reserve Ratio (RR) | Credit Multiplier $\displaystyle \left(\frac{1}{RR}\right)$ | Credit Creation (Initial Deposit x Credit Multiplier) |
| I | $\displaystyle 0.2$ | $\displaystyle \frac{1}{0.2}$ = $\displaystyle 5$ | $\displaystyle 1,000$ x $\displaystyle 5$ = ₹$\displaystyle 5,000$ |
| II | $\displaystyle 0.5$ | $\displaystyle \frac{1}{0.5}$ = $\displaystyle 2$ | $\displaystyle 1000$ x $\displaystyle 2$ = ₹$\displaystyle 2,000$ |
The above example, depicts the effect of rise in Reserve Ratio on credit creation by the commercial banks.
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