King’s College

S7 Economics Revision Test: Creation of Deposit, Consumption and Investment

Suggested Solutions
Total marks: 30

Section A: Multiple-choice Questions (6 marks)

1. A 2. A 3. C 4. B 5. D 6. A

Section B: Short Questions (24 marks)

1. (a) As money supply equals to the summation of currency held by non-bank public and the amount of
bank deposits, Ms = $500 + $4000 = $4500. (2 marks)
(b) (i) If the public deposits the excess cash, i.e. $100, into the banking system, the amount of reserves
held by bank and the amount of deposits will rise by $100. If banks cannot lend out any amount of
the excess reserves, there will be no further increase in bank deposits. Then money supply = $400
+ $(4000 +100) = $4500.
The balance sheet of the banking system will be as follows:
Assets ($) Liabilities ($)
Reserves 1,100 Deposits 4,100
Loans 3,000
(3 marks)
(b) (ii) From the above balance sheet, we can see that the required reserve ratio is equal to 25% and the
maximum banking multiplier is equal to 4. It means that an increase in reserves by $1 can
increase deposits by $4. With an increase in reserves by $100, there will be excess reserves of $75
held by banks. If banks can lend out all the excess reserves, the increase in deposits will be equal
to $400. Then money supply = $(400 + 4400) = $4800.
The balance sheet of the banking system will be as follows:
Assets ($) Liabilities ($)
Reserves 1,100 Deposits 4,400
Loans 3,300
(3 marks)
(c) Money supply consists of currency held by non-bank public and bank deposits. If there is a
reduction in public’s desire to hold cash, the amount of currency held by non-bank public will fall.
This in turn will lead to a rise in reserves held by bank. Under a fractional reserve system, banks
will have excess reserves.
However, whether the money supply will be affected depends on whether banks can lend out
some or all of the excess reserves. If banks cannot lend out any of their excess reserves, there
will be no change in money supply. If banks can lend out part or all of the excess reserves, the
amount of deposits and in turn the money supply will increase. (2 marks)

2. Assume that there is no further cash leakage and the banking system keeps no excess reserves in the process
of credit creation/contraction. The banking multiplier equals 1/0.25 = 4.
CU = cash held in non-bank public
D = deposits
R = reserves
(a) Change in deposits
= ∆R × banking multiplier
= $500 × 4
= $2000
Change in money supply
= ∆D + ∆CU
= $2000 – $500
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 = $1500 (2 marks)
(b) Change in deposits
= ∆R × banking multiplier
= –$500 × 4
= –$2000
Change in money supply
= ∆D + ∆CU
= –$2000 + $500
= –$1500 (2 marks)
(c) Change in deposits
= ∆R × banking multiplier
= $500 × 4
= $2000
Change in money supply
= ∆D + ∆CU
= $2000 + $0
= $2000 (2 marks)

3. The paradox of thrift describes the phenomenon where an increase in saving will decrease income and may
eventually lead to no increase in saving, or even less saving. So, thriftiness, as a virtue to an individual, can
be disastrous to the whole economy.
An increase in the marginal propensity to save, or an autonomous increase in the saving function, ceteris
paribus, will lead to a decrease in the level of equilibrium income.
[It states that when an individual increases his desired saving, he accumulates more wealth and becomes
richer. But an increase in national saving (or aggregate private saving) will result in a fall in national
income, making the country as a whole poorer. In the end, the equilibrium level of saving will not increase
either. (HKAL 05 II Q.2(a)]

However, saving and investment are not usually independent. People would normally spend the increase in
saving on investment. This will lower the interest rate and shift the investment function upward. Equilibrium
income will then remain unchanged, but the future income of the economy will rise due to the extra
investment. (8 marks)

Supplementary materials (page 125, Understanding Macroeconomics HKAL 1 by Wong Yuen Chi):
What determine whether saving is detrimental or beneficial?
If prices or interest rate is flexible downward, the unspent income will re-enter the circular flow and saving
is beneficial.

When saving increases, inventories are accumulated. If price is flexible, product price will drop until
aggregate expenditure absorbs all output.

Alternatively, when saving increases, idle funds are accumulated in banks. If interest rate is flexible,
interest rate would drop until investment absorbs all the saving.

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