How do commercial banks „create credit‟? What are the limitations to this credit creation? (12 marks)
Explain the concept of liquidity trap (8 marks)
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ANSWER
Commercial banks „create‟ credit through a process known as credit creation. Credit creation is defined as a process by which commercial banks advance loans from deposits net of a statutory cash ratio requirement. This involves lending out money (from deposits) at an interest. This is because banks know from experience that only a fraction of its deposits will be demanded in cash at any particular time. Thus, the ability of banks to create deposit money depends on the fact that bank deposits need to be only fractionally backed by notes and coins.
Because banks do not need to keep 100 percent reserves, they can use some of the money deposited to purchase income-yielding investments. The multiple expansion of credit arises from the re-deposit (created deposit) of money which has been borrowed. Nevertheless, banks cannot distinguish between their initial deposits and created deposits.
What is Liquidity Trap?
Refers to the minimum rate of interest payable to persons to persuade them to part with money in terms of savings or investment i.e. interest being the payment for the loss of liquidity. It inversely relates the speculative demand for money to the interest rate (as a return).
This concept is derived from the Keynesian Theory (monetary theory of interest) of speculative demand for money. It states that the rate of interest is determined by the supply of money (savings) and the desire to hold one‟s wealth in money/cash (demand for money).
It looks at money as a store of value (in itself), that is, money is held as an asset in preference to income- yielding assets such as a government bond.
Lord John Maynard Keynes (1936) explains the speculative demand for money in terms of the buying and selling of government securities or treasury bills (TBS) on which the government pays a fixed rate of interest.
Its assumed that the speculative demand for money is interest elastic such that the demand curve slopes downwards from left to right. At the liquidity trap point, the demand cure is perfectly elastic implying that any interest rate below the persuasive minimum interest rate represents an absolute preference for liquidity situation i.e. no spectacular will be willing to (part with money) invest in government securities.
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