Question 5 of 11intermediate💡 UnderstandShort Answer3 marks

What could be the reason for the higher interest rate earned on fixed deposits as compared to a savings account?

Correct Answer

Fixed deposits offer higher interest rates compared to savings accounts because the money is deposited for a fixed, longer period (such as 3 or 5 years) during which the depositor cannot withdraw it.

This allows banks to use the deposited money for a guaranteed duration to lend to borrowers or invest, providing banks with greater certainty and stability.

In return for this commitment and reduced liquidity for the depositor, banks reward fixed deposit holders with higher interest rates.

Savings accounts allow frequent withdrawals and deposits, providing more flexibility but earning lower interest due to the uncertainty of how long the money will remain with the bank.

Exercise: Questions and activities | Q: 5 | (Page Page 19)
For More Understanding

Explanation

The chapter describes fixed deposit accounts as one-time deposits kept for a fixed period like 3 or 5 years, after which the bank returns the original amount plus interest which is usually higher than what a savings account offers. In contrast, savings accounts allow money to be added or withdrawn, though there are limits on withdrawal frequency. The longer lock-in period in fixed deposits enables banks to plan their lending activities better, justifying the higher interest rate offered.

Solution Steps

  1. Fixed deposits lock in money for a fixed, longer period (3 or 5 years) during which withdrawal is not allowed

  2. Banks can use FD money for a guaranteed duration to lend or invest, providing greater certainty and stability

  3. Banks reward FD holders with higher interest rates in return for the depositor's commitment and reduced liquidity

  4. Savings accounts offer more flexibility with frequent withdrawals and deposits, but earn lower interest due to uncertainty of fund availability

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