Assume all banks have the same reserve requirement, 10% and you just remember yo

Question

Assume all banks have the same reserve requirement, 10% and you just remember you buried $1,000 in your backyard 2 years ago. You take the thousand dollars to your bank and deposit it.

a) When the rounds have been exhausted, what is the total amount of deposits in the banking system? Show and explain.

b) Using the total deposit number, show the amount of required reserves created and the amount of loans created by this process.

c) You will have to think a bit about this one. Using the $1,000 deposit and reserve requirement is still 10%, suppose I tell you that in each round, 10% is withdrawn for cash and this is a leakage. Show and explain what is the multiplier now and what would be total deposits at the end of the process.

d) From parts ‘a’ and ‘c’, what has happened and why?

e) What is the size of the FOMC and where do they come from?

Explanation / Answer

Answer:

a) Whenever bank receives a fresh round of deposit, it is required to keep a percentage of it as reserves with itself or the Federal Bank. This percentage of amount is known as Reserve Requirement (Here it is 10%).

The bank can then loan out the left money.

What happens is that, banks loan out the money only by depositing the loan amount in the borrowers bank A/C. So, this creates a fresh deposit with the bank.

Bank again keeps the Reserve Requirement of this amount and loans out the rest amount.

This process continues till the Initial Deposit = Total Reserve. This process is thus known as Money Multiplier Effect, where money is used to create money by commercial banks and is obtained by dividing total bank deposits by the reserve requirement.

i.e. $1000 / 0.1 = $10,000

This can also be explained with the help of following table:

Reserves =

Deposit x RR

Amount Loaned Out =

Deposit - Reserves

So, the total amount of deposits in the banking system is $10,000.

b) As already shown above, we have

Amount of required reserved created = $ 1000

Amount of loans created by this process = $ 9000

c) When there is withdrawal of cash this is known as leakage. This reduces the money multiplier, and the same is now calculated as :

m = ( 1+ Drainage Ratio ) / ( Reserve Requirement Ratio + Drainage Ratio )

So, here m = (1 + 0.10 ) / (0.10 + 0.10 ) = 5.5

Thus, Total deposits at the end of the process will be $1000 * 5.5 = $5,500

d) From Parts 'a' to 'c' the money multiplier has fallen from 10 to 5.5. This has happened on account of leakage that took place at each round in Part B.

When a part of the loan amount is withdrawn in form of cash, banks are left with less deposits and excess reserve at each round and this reduces their ability to generate loans. And thus money multiplier falls and in effect money created falls.

e) FOMC stands for Federal Open Market Committee. It consists of twelve members - the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis. The rotating seats are filled from the following four groups of Banks, one Bank president from each group: Boston, Philadelphia, and Richmond; Cleveland and Chicago; Atlanta, St. Louis, and Dallas; and Minneapolis, Kansas City, and San Francisco. Nonvoting Reserve Bank presidents attend the meetings of the Committee, participate in the discussions, and contribute to the Committee's assessment of the economy and policy options.

Round Deposit Amount

Reserves =

Deposit x RR

Amount Loaned Out =

Deposit - Reserves

1 $1,000 $100 $900 2 $900 $90 $810 3 $810 $81 $729 4 $729 $72.90 $656.10 and so on.... Total $10,000 $1000 $9000

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