Suppose that the reserve requirement is 5.5%. If 4 firms deposit a total of $1 m

Question

Suppose that the reserve requirement is 5.5%. If 4 firms deposit a total of $1 million into a demand deposit account at the First national Bank, what is the total deposit creation in the banking system using the simple deposit multiplier?

Consider the preceding question using the money multiplier. If the currency ratio is 40% and the excess reserve ratio is 1%, what is the change in money supply?

If the reserve requirement were eliminated (and the currency ration is 40% and the excess reserve ratio is 1%), how much would this change size of the money supply?

What is the practical justification of the reserve requirement, besides as a monetary policy tool?

Explanation / Answer

a) Simple deposit multiplier = 1 / RR
RR = 5.5% = 0.055

Simple deposit multiplier = 1/0.055 = 18.18

So total deposit creation in bank = Simple deposit multiplier x total deposit = 18.18 x 1 million = 18.18 million

b) Monetary base = CR x Deposit + ( RR + ERR) x D
RR = Reserve ratio = 5.5% = 0.055

ERR = Excessive reserve ratio = 1% = 0.01

CR = currency ratio = 40% = 0.4

D = deposit = 1 million = 1000000

Monetary base = 0.4 x 1000000+ ( 0.055+0.01) x 1000000

Monetary base = 456000$

Money multiplier = ( CR +1) / (CR+ RR)

Money multiplier = (0.4+1) / (0.4+0.055)

Money multiplier = 3.078

So

Change in money supply = 3.078 x 456000 = 1403568

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