Question

The government decides to place limits on the interest rates banks can pay their depositors. Seeing that alternative investments pay higher interest rates, depositors withdraw their funds from banks and place them in bonds. What will be the impact on banks' balance sheets?

A. Banks will keep size of their balance sheets the same so the supply of loans will be kept constant.
B. Banks will be forced to shrink the size of their balance sheets so the supply of loans will fall.
C. Banks will be forced to increase the size of their balance sheets so the supply of loans will rise.

Answer 1

Answer:

(B)

Explanation:

Put simply here, an interest rate tells how much (amount of currency) will be earned or paid customers on interest-bearing deposits or loans.

If depositors withdraw their funds, banks will be forced to shrink the size of their balance sheets (selling assets) so the supply of loans will fall, resulting in a reduction in consumption.

This decision by the government has another implication over time, as there is now increase in the demand for bonds (since the banks have reduced the supply for loans), it would lead to decreased interest rates making it cheaper for firms to borrow again.