Question 2 [ 25 marks]

The State Bank of Pakistan (SBP) is now fearing that COVID-19 is going to have a recessionary impact on the economy of Pakistan. It is being expected that many commercial banks may not be able to repay their debts and could go out of business. The SBP announced reserve ratio is 10%.

a.What would this lead to in the immediate term? [2]

A common characteristic of all recessions is a rise in the bankruptcy rate. The debt of bankrupt companies, largely held by banks, becomes highly discounted or worthless and will lead some deposit holders to fear for the solvency of their bank.

b.I hear this on the news and withdraw Rs. 10 lakh from my account the next day and put it in my safe at home. What happens to the bank when I withdraw this money? Think about the process we did in the lecture, but in reverse. You can use the book to draw T-accounts to illustrate your answer. Remember that the T-account must balance. You can stop after the second bank, and then show the overall effect on money supply in the entire banking system [10]

c.By how much has the money supply changed by the time this process ends? [4]

d.The effect on money supply could actually be much larger than this as banks will become more cautiousthey worry that their borrowers might not be able to repay fresh loans taken during the economic lockdown induced by COVID-19. What other impact could this bank behaviour have on the macroeconomy?[6]

e.In these circumstances, which of the 3 roles of the SBP should be highlighted in the press release expected on May 15^th regarding Pakistan's new COVID-19 monetary policy? You don't need to give the policy, just the message that the SBP would like to give consumers and banks about SBP role in the banking sector. [4]