The public is initially holding currency equal to $1500 and no deposits. There i

Question

The public is initially holding currency equal to $1500 and no deposits. There is no banking system. A banking system is created at which time the public deposits $400 of its currency into the system. Banks desire to hold 10% of deposits as reserves and lend out 90% of deposits to households; banks do not hold securities.

a. Use bank balance sheets to illustrate three-iterations of the deposit creation process (each new loan counts as one- iteration of the deposit creation process). Assume households deposit the proceeds of the first and second loan into the banking system and hold the proceeds of the third loan as currency.

b. After the third loan is extended by banks, how much money, M1, exists in the economy? Support your response using the definition of M1.

c. Use the simply money multiplier to determine the total value of deposits created after an infinite number of iterations of the deposit creation process

Explanation / Answer

a) 1500 is the currency held by the public.

now 400 is deposited, where 10% of 400 i.e 40 is held as reserves and lend out 360 (400-40)

if households deposit 360, bank keeps 10% of 360

= 36 and lend 360-36 = 324

again household deposits 324 in bank, 10% of 324 is kept

=32.4 and lend 291.6

now households keep 291.6 as currency.

b) M1 = (1500-400) + 291.6

1100 + 291.6 = 1391.6

c) total reserves held by the bank = 40+36+32.4

= 108.4

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