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Liquidity Ratio

R

rinishj28

Member
The text book says that:
1. If banks collectively choose to hold a lower liquidity ratio, they will have surplus liquidity.

As seen in the theory of credit creation, even if a single bank operates with a lower liquidity ratio it'll have surplus liquidity.

So what's special about banks holding a lower liquidity ratio collectively?

2. Although CDs are liquid to an individual bank, they do not add to the liquidity of the banking system as a whole. By using them for credit creation, the banking system is operating with a lower overall liquidity ratio.
Please Explain.

Thank You
 
Last edited by a moderator:
Hi,

Please could you provide the page numbers in the text book, to make it easier to find the points you are referring to - thanks. :)

I don't think there is any "special" about banks collectively holding a lower liquidity ratio compared to just a single bank doing so. If a single bank decides to reduce its liquidity ratio, it will have surplus funds to lend and so will increase its lending, leading to an increase in broad money. Exactly the same point applies if several banks pursue the same policy. The only difference is that there will be a more widespread / larger increase in overall lending and hence in overall broad money.

Yes, although CDs are liquid to an individual bank, they do not add to the liquidity of the banking system as a whole. For example, if Bank A sells a CD to Bank B for cash, then the overall cash in the banking system is unchanged - it's simply transferred from B to A. If Bank A then uses this extra cash to increase its lending, then overall lending will higher, with the same cash base, hence overall liquidity will be slightly lower. :)
 
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