Essay on Tutorial 6 2015 1 Answers

ECON110
TUTORIAL 6

1. Read the following (edited) article about China’s central bank cut in the (required) reserve ratio.1 Answer the questions that follow.2

China's central bank on Sunday cut the amount of cash that banks must hold as reserves, the second industry-wide cut in two months, adding more liquidity to the world's second-biggest economy to help spur bank lending and combat slowing growth. The People's Bank of China (PBOC) lowered the reserve requirement ratio (RRR) for all banks by 100 basis points to 18.5 percent, effective from April 20.

"Though the growth in the first quarter met the official target of around 7 percent for 2015, the slowdown in several areas, including industrial output and retail sales, has caused concern," said a report published by the official Xinhua news. The latest cut, the deepest single reduction since the depth of the global crisis in 2008, shows how the central bank is stepping up efforts to ward off a sharp slowdown in the economy. "The size of the cut is more than expected," said Shenwan Hongyuan Securities analyst Chen Kang. "It's going to release around a trillion yuan (in liquidity) at least."

Weighed down by a property downturn, factory overcapacity and local debt, growth is expected to slow to a quarter-century low of around 7 percent this year from 7.4 percent in 2014, even with expected additional stimulus measures. However, the last reserve ratio cut was seen as more defensive by some economists, as it served primarily to offset increasing capital outflows that were exerting a drain on the money supply, making it difficult to guide real lending rates down.3 Chinese bankers have proven resistant to extending more credit, saying they are also under orders to maintain profitability and reduce the amount of bad loans on their books, but their intransigence appears to have frustrated Beijing.

a) Explain how a decrease in the reserve ratio could increase the amount of loans available in China. (2 marks)

This is just about the credit creation process.

b) Why does the Government of China (or the advising economists) hope that lowering the reserve ratio will combat the slowdown in industrial output and retail sales? Explain. (2 marks) Use the AE diagram. (1 mark)

This is about the impact of the credit creation process on the goods and services sector. The idea here is that more loans will stimulate investment & consumption expenditure.

c) Fewer households in China (say compared to those in Australia) are able to obtain loans from the official banking sector to purchase housing and consumer durables. What does this say about the relative policy effectiveness of decreasing the reserve ratio in China (compared to Australia)? Explain. (2 marks) Use the AE diagram. (1 mark)

If less people have access to the official sector there will limit the amount of new credit & its ultimate impact on GDP. Students may show on different diagrams the relative impacts on the AE diagram.

d) What is the potential problem with lowering the reserve ratio when the banks in China have problems with bad loans? (2 marks)

Less reserves associated with loans, so if investments go wrong a greater disparity between deposits and reserves

e) Why have increases in loans not decreased the interest rate in China? (Use the money demand and money supply diagram in Ch.9). (1 mark)

Show the money supply line only smaller a small amount or

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