Suppose you take $1000 you keep under your mattress and deposit it in a checking

Question

Suppose you take $1000 you keep under your mattress and deposit it in a checking account at your local bank, which has and keeps no excess reserves.

(a) If the required reserve ratio of reserves to (checkable) deposits is 5 percent, what is the maximum amount that this bank will loan of the $1000 cash deposit? (Note: Just ask yourself, how much of this new deposit must the bank hold as Excess Reserves? So how much of the $1000 can it then loan?)

(b) So assuming that the bank in (a) lends out what it can of the $1000 deposit and that successive banks lend out all they can of their increased deposits in the money-creation process, by how much will the money supply expand? (Hint: Simply multiply your answer in (a), which is the increase in Excess Reserves, times the money multiplier. This is the amount of increase in the money supply from the time of the first loan made to the end of the money supply creation process.)

(c) Your answer to (b) is the total amount of money created from the original deposit of $1000 of cash. But how can that be? In our example in class, when the Fed purchases securities from a bond dealer, who deposits proceeds from the sale of the bonds in a bank account, the money supply increases in that first step by the amount of the deposit in addition to the expansion you computed in (b). Here, though, we’re saying that the money supply, M1, in the first step (a) does not increase. Why not?

(Hint: remember that M1 = currency in hands of public + demand deposits)

Explanation / Answer

A) required reserves are 5%. Therefore the bank has an excess reserves of 95% for any amount of deposit. When you deposit $1,000 in your bank account, the bank will keep 5% or $50 and will give loans of the remaining amount which is $950. This is the amount of excess reserves that the bank will lend.

B) the value of the money multiplier in this case is 1 / RR which is 1 / 5 %. Therefore the multiplier is 20. When the deposits are increased by $1,000, total money supply will be increased by 20 x 1000 which gives $20,000.

C) it is absolutely correct that the money supply will increase by $1,000 in the first phase. But the person who has acquired the loan will definitely spend some or all of the money. It may be possible that he's depositing a portion of that money in his own bank account and is spending the rest. We generally believed that the maximum money supply can be increased when the entire loan is deposited in the bank account again. So in further rounds, every borrower will deposit the entire money in the bank account so that once deposited amount of $1,000 keeps it self passing within the banking system.

In this manner a single deposit of $1,000 will multiply itself to become $20,000.

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