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

The Central Bank of Nigeria increases the mandatory Cash Reserve Ratio for commercial banks from 10%10\% to 20%20\%. Assuming an initial cash deposit of N80,000\text{N}80,000 into the commercial banking system with no cash leakages, how does this policy shift impact the total credit expansion capacity of commercial banks?

  1. The credit multiplier decreases from 1010 to 55, reducing total credit expansion by N400,000\text{N}400,000Answer
  2. B
    The credit multiplier increases from 0.100.10 to 0.200.20, expanding total credit by N8,000\text{N}8,000
  3. C
    The total credit expansion decreases from N72,000\text{N}72,000 to N64,000\text{N}64,000
  4. D
    The maximum credit expansion increases from N400,000\text{N}400,000 to N800,000\text{N}800,000

Answer

The credit multiplier decreases from 1010 to 55, reducing total credit expansion by N400,000\text{N}400,000.
The total capacity of commercial banks to create credit is inversely related to the Cash Reserve Ratio (CRRCRR), expressed as Total Credit=Initial Deposit×1CRR\text{Total Credit} = \text{Initial Deposit} \times \frac{1}{\text{CRR}}. When CRR is 10%10\%, the multiplier is 1010, creating up to N800,000\text{N}800,000. When CRR rises to 20%20\%, the multiplier falls to 55, creating up to N400,000\text{N}400,000. The net policy effect is a reduction in potential credit expansion of N400,000\text{N}400,000.

Step-by-Step Solution

1
Calculate the initial credit multiplier and total credit expansion at 10% Cash Reserve Ratio (CRR)
Initial Multiplier = 10.10=10\frac{1}{0.10} = 10; Initial Expansion = N80,000×10=N800,000\text{N}80,000 \times 10 = \text{N}800,000
The credit multiplier is the inverse of the reserve requirement ratio.
2
Calculate the new credit multiplier and total credit expansion at 20% Cash Reserve Ratio (CRR)
New Multiplier = 10.20=5\frac{1}{0.20} = 5; New Expansion = N80,000×5=N400,000\text{N}80,000 \times 5 = \text{N}400,000
An increase in CRR forces banks to hold more cash in reserve, reducing the fraction available for lending.
3
Determine the net change in credit expansion capacity
Net Reduction = N800,000−N400,000=N400,000\text{N}800,000 - \text{N}400,000 = \text{N}400,000
Subtracting the new total credit expansion capacity from the initial capacity yields the reduction in credit creation.

Key Concept

Credit Multiplier and Monetary Reserve Requirements
Estimated Time:1m 30s
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Topics

Commercial Banks: Functions, Services, and Credit Creation

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