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Difficulty: MediumCommercial Banks: Functions and Credit Creation

A commercial bank receives an initial primary cash deposit of ₦200,000₦200,000. If the banking system consequently generates a net credit creation of ₦800,000₦800,000, what is the mandatory cash reserve ratio set by the central bank?

  1. 20%20\%Answer
  2. B
    25%25\%
  3. C
    15%15\%
  4. D
    80%80\%

Answer

The cash reserve ratio set by the central bank is 20%20\%.
Total deposits created by the banking system equal the initial primary deposit plus the net credit created (₦200,000+₦800,000=₦1,000,000₦200,000 + ₦800,000 = ₦1,000,000). Using the total deposit formula Total Deposits=Initial Deposit/Cash Reserve Ratio\text{Total Deposits} = \text{Initial Deposit} / \text{Cash Reserve Ratio}, we have 1,000,000=200,000/CRR1,000,000 = 200,000 / \text{CRR}, which simplifies to CRR=200,000/1,000,000=0.20\text{CRR} = 200,000 / 1,000,000 = 0.20 or 20%20\%.

Step-by-Step Solution

1
Calculate the total deposit expansion in the banking system
Total Deposits = Initial Deposit + Net Credit Created = ₦200,000+₦800,000=₦1,000,000₦200,000 + ₦800,000 = ₦1,000,000
Net credit created represents total secondary expansion excluding the original primary deposit.
2
Calculate the credit multiplier
Credit Multiplier = Total Deposit Expansion / Initial Deposit = ₦1,000,000/₦200,000=5₦1,000,000 / ₦200,000 = 5
The credit multiplier measures the factor by which deposits expand relative to the original cash injection.
3
Determine the cash reserve ratio (CRR)
Cash Reserve Ratio = 1/Credit Multiplier=1/5=0.20=20%1 / \text{Credit Multiplier} = 1 / 5 = 0.20 = 20\%
The credit multiplier is the reciprocal of the cash reserve ratio.

Key Concept

Credit Creation and Cash Reserve Ratio Relationship
Estimated Time:1m 30s
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Topics

Commercial Banks: Functions and Credit Creation