. The money creation process Suppose First Main Street Bank, Second Republic Ban
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Question
. The money creation process
Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 25%. The Federal Reserve buys a government bond worth $1,800,000 from Darnell, a client of First Main Street Bank. He deposits the money into his checking account at First Main Street Bank.
Complete the following table to reflect any changes in First Main Street Bank's T-account (before the bank makes any new loans).
Complete the following table to show the effect of a new deposit on excess and required reserves when the required reserve ratio is 25%.
Hint: If the change is negative, be sure to enter the value as negative number.
Now, suppose First Main Street Bank loans out all of its new excess reserves to Beth, who immediately uses the funds to write a check to Andrew. Andrew deposits the funds immediately into his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Darnell, who writes a check to Eleanor, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new excess reserves to Kyoko as well.
Fill in the following table to show the effect of this ongoing chain of events at each bank. Enter each answer to the nearest dollar.
Assume this process continues, with each successive loan deposited into a checking account and no banks keeping any excess reserves. Under these assumptions, the $1,800,000 injection into the money supply results in an overall increase of in demad deposit
Assets Liabilities ............ .......... ................. ...............Explanation / Answer
Always remember balance sheet must match i.e. Assets-Liabilities = Equity. Here Equity = 0 and hence assets should be equal to liabilities. Liability is what the bank must return the depositor i.e. the whole $1,800,000. Assets will comprise of reserves (required reserves + excess reserves which will equal to the original $1.8 mn)
The required reserves given to Federal Bank by First Main Bank (25% * $1,800,000) = $450,000
Excess reserves are the demand deposit minus the reserve given to the Federal Bank i.e. 75% * $1,800,000
Assuming the process continues, this will form an infinite geometric progression :
b1 = 0.75 * a1, c1 =0.75* b1 -> c1 = 0.75*0.75* a1
From table above, total increase in demand deposit will be $1,800,000 + 0.75 * $1,800,000 +0.75 * 0.75* $1,800,000 +..
which is $1,800,000 / (1-0.75) = $1,800,000 * 4 = $7,200,000
Therefore an overall increase in demand deposit of $7,200,000 with $1,800,000 injection of money
Assets Liabilities +$1,800,000 +$1,800,000Related Questions
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