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Difficulty: MediumCommercial Banks: Functions, Services, and Credit Creation

A retail business makes a fresh cash deposit of N600,000\text{N}600,000 into a commercial bank. The Central Bank mandates a Cash Reserve Ratio of 10%10\%, and the commercial bank voluntarily retains an additional 10%10\% of deposits as excess liquid reserves. Assuming no cash leakages in the economy, what is the maximum amount of derivative deposits the commercial banking system can create from this initial deposit?

  1. N2,400,000\text{N}2,400,000Answer
  2. B
    N3,000,000\text{N}3,000,000
  3. C
    N5,400,000\text{N}5,400,000
  4. D
    N120,000\text{N}120,000

Answer

N2,400,000\text{N}2,400,000
The effective reserve ratio is 20%20\% (10%10\% mandatory plus 10%10\% voluntary excess reserves). The credit multiplier is 10.20=5\frac{1}{0.20} = 5. Total deposit expansion equals N600,000×5=N3,000,000\text{N}600,000 \times 5 = \text{N}3,000,000. Subtracting the primary deposit of N600,000\text{N}600,000 yields derivative deposits of N2,400,000\text{N}2,400,000.

Step-by-Step Solution

1
Calculate the effective total reserve ratio
Total Reserve Ratio (r)=10%+10%=20%=0.20\text{Total Reserve Ratio } (r) = 10\% + 10\% = 20\% = 0.20
Both mandatory cash reserves and voluntary excess reserves reduce the proportion of deposits available for lending.
2
Determine the credit multiplier
\text{Credit Multiplier } (K) = \frac{1}{r} = \frac{1}{0.20} = 5
The credit multiplier is the reciprocal of the total reserve ratio.
3
Calculate total deposit expansion
\text{Total Deposit Expansion} = \text{Initial Deposit} \times K = \text{N}600,000 \times 5 = \text{N}3,000,000
The total volume of money created in the banking system includes both primary and secondary deposits.
4
Deduct the primary cash deposit to find derivative deposits
\text{Derivative Deposits} = \text{Total Deposit Expansion} - \text{Initial Cash Deposit} = \text{N}3,000,000 - \text{N}600,000 = \text{N}2,400,000
Derivative deposits represent the loan-created secondary expansion separate from the original cash influx.

Key Concept

Credit Creation Constraints and Derivative Deposits Calculation
Estimated Time:1m 30s
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Topics

Commercial Banks: Functions, Services, and Credit Creation

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