Chapter 14, Problem 5P

Sub-part

A

To determine

The amount that the bank should lend, assuming that it holds no excess reserves.

Explanation of Solution

a. If Bank A wishes to hold no excess reserves form the deposit of $1,000, then the deposits would go up by $1,000 in liabilities. In the assets, the required reserves increase by $100 (10% required reserve of $1,000) and loans increase by $900 as the bank lends all the remaining reserves holding no excess reserve.

Bank A's balance sheet
Assets		Liabilities
Reserves	$100	Deposits	$1,000
Loans	$900

Economics Concept Introduction

Introduction:

The Federal Reserve and banking system are responsible for the creation of money in the economy. The first step of this money creation process starts when the Federal Reserve injects money in the economy by buying bonds. This money is stored in a bank. Then, the bank would keep the required reserves with themselves, and lent the remaining excess reserves. These excess reserves will then be stored with some other bank and the other bank would also keep the required reserve and make a loan for the remaining amount. These excess reserves keep flowing in the economy, thus, creating money at every stage. A bank’s balance sheet has the deposit account and capital account on the liabilities side, and cash reserves, required reserves, loans, and securities are on the asset side of the bank’s balance sheet that are affected by the money creation process.

Sub-Part

B

To determine

The changes in the balance sheet of bank B, when maximum amount is lent..

Explanation of Solution

The Bank B receives a deposit of $900 which it plans to lend keeping the required reserve. Thus, it will have similar effects as in part A. Bank B’s deposits increase by $900, and its reserves and loans increase by $90 (10% required reserve of $900) and $810 respectively.

Bank B's balance sheet
Assets		Liabilities
Reserves	$90	Deposits	$900
Loans	$810

Economics Concept Introduction

Introduction:

The Federal Reserve and banking system are responsible for the creation of money in the economy. The first step of this money creation process starts when the Federal Reserve injects money in the economy by buying bonds. This money is stored in a bank. Then, the bank would keep the required reserves with themselves, and lent the remaining excess reserves. These excess reserves will then be stored with some other bank and the other bank would also keep the required reserve and make a loan for the remaining amount. These excess reserves keep flowing in the economy, thus, creating money at every stage. A bank’s balance sheet has the deposit account and capital account on the liabilities side, and cash reserves, required reserves, loans, and securities are on the asset side of the bank’s balance sheet that are affected by the money creation process.

Sub-Part

C

To determine

The same process for banks C, D and E.

Explanation of Solution

b. Similar, effects will take place in Banks C, D, and E. Each of their deposit will increase, and, holding 10% of reserves, their loans will increase too.

Bank C's balance sheet
Assets		Liabilities
Reserves	$81	Deposits	$810
Loans	$729

Bank D's balance sheet
Assets		Liabilities
Reserves	$72.90	Deposits	$729.00
Loans	$656.10

Bank E's balance sheet
Assets		Liabilities
Reserves	$65.61	Deposits	$656.10
Loans	$590.49

Economics Concept Introduction

Introduction:

The Federal Reserve and banking system are responsible for the creation of money in the economy. The first step of this money creation process starts when the Federal Reserve injects money in the economy by buying bonds. This money is stored in a bank. Then, the bank would keep the required reserves with themselves, and lent the remaining excess reserves. These excess reserves will then be stored with some other bank and the other bank would also keep the required reserve and make a loan for the remaining amount. These excess reserves keep flowing in the economy, thus, creating money at every stage. A bank’s balance sheet has the deposit account and capital account on the liabilities side, and cash reserves, required reserves, loans, and securities are on the asset side of the bank’s balance sheet that are affected by the money creation process.

Sub-Part

D

To determine

The total change in the money supply as a consequence of $1000 initial deposit.

Explanation of Solution

The change in the money supply takes place when the excess reserves are lent out by the first bank. The formula to calculate the change in money supply is change in fresh reserves times the reciprocal of the reserve ratio. Thus, $\Delta M=\Delta freshreserves\times \frac{1}{r}=\$1,000\times \frac{1}{0.1}=\$10,000.$

Economics Concept Introduction

Introduction:

The Federal Reserve and banking system are responsible for the creation of money in the economy. The first step of this money creation process starts when the Federal Reserve injects money in the economy by buying bonds. This money is stored in a bank. Then, the bank would keep the required reserves with themselves, and lent the remaining excess reserves. These excess reserves will then be stored with some other bank and the other bank would also keep the required reserve and make a loan for the remaining amount. These excess reserves keep flowing in the economy, thus, creating money at every stage. A bank’s balance sheet has the deposit account and capital account on the liabilities side, and cash reserves, required reserves, loans, and securities are on the asset side of the bank’s balance sheet that are affected by the money creation process.

Sub-Part

E

To determine

The effect on the total change in the money supply with holding the level of excess reserves.

Explanation of Solution

If each of the banks plans to hold 5% excess reserves, then the money supply will reduce by 5%. Thus, the reserve ratio increases from 10% to 15%. With this effect, the change in money supply will be as follows:

  $\Delta M=\Delta freshreserves\times \frac{1}{r}=\$1,000\times \frac{1}{0.15}=\$6,\mathrm{666.67.}$

Economics Concept Introduction

Introduction:

The Federal Reserve and banking system are responsible for the creation of money in the economy. The first step of this money creation process starts when the Federal Reserve injects money in the economy by buying bonds. This money is stored in a bank. Then, the bank would keep the required reserves with themselves, and lent the remaining excess reserves. These excess reserves will then be stored with some other bank and the other bank would also keep the required reserve and make a loan for the remaining amount. These excess reserves keep flowing in the economy, thus, creating money at every stage. A bank’s balance sheet has the deposit account and capital account on the liabilities side, and cash reserves, required reserves, loans, and securities are on the asset side of the bank’s balance sheet that are affected by the money creation process.