Lesson eLearning

Describe how fractional reserve banking expands the money supply, and compute the total increase in money supply when the banking system has total deposits of Rs. 5,00,000, the required reserve ratio is 10%, and the RBI purchases government securities worth Rs. 3,000.

hard 5 marks Class 10 · Economics · Money and Credit
Answer
Rs. 30,000

The correct answer is Rs. 30,000 — Step 6: Explain that each round of lending further increases deposits until reserves are exhausted, leading to the multiplier effect.

Step-by-step solution

  1. Step 1: RBI’s purchase adds Rs. 3,000 to bank reserves.
  2. Step 2: Required reserves on the new deposits = 3,000 × 0.10 = 300.
  3. Step 3: Excess reserves = 3,000 – 300 = 2,700.
  4. Step 4: Money multiplier = 1 ÷ 0.10 = 10.
  5. Step 5: Total increase in money supply = 3,000 × 10 = 30,000.
  6. Step 6: Explain that each round of lending further increases deposits until reserves are exhausted, leading to the multiplier effect.
Common mistake: Ignoring the multiplier and using the injection amount directly

Concept tested: Fractional reserve banking

Published · How this solution was prepared and checked

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