Chapter 25, Problem 4CYU

To determine

The consequent expansion in the money supply if borrowers keep half of the loan amount as cash and deposit rest of the amount.

Explanation of Solution

Given Information:

Deposit made by Person S is $1000

Reserve ratio is 10% (assumed)

Banks expand their deposits through lending. If $1000 is deposited by Person S then bank can lend $900 further keeping reserve of $100 (10% of $1000). If $900 is deposited by other borrower in the same bank then the amount that can be further used for lending will be $810 (10% of $900). Similarly, if $810 is lend further if the whole amount is deposited by the borrower then bank can lend $729 keeping $81 as reserve.

The total money supply expansion will be $2,439(900+$810+$729).

For instance, if half of the money is deposited after making deposit of $1000 by Person S then money expansion will be:

• $900 available for lending after keeping reserve of $100 (10% of $1000)
• $405 available for lending after keeping reserve of $45 (10% of 450)
• $182.25 available for lending after keeping reserve of $20.25 (10% of $202.5)

Total expansion will be less which is $1487.25 ($900+$405+$182.25)

Economics Concept Introduction

Federal Reserve System: It is a central bank that looks after the banking system of the country along with the control of its monetary base. Monetary base is the sum of circulating currency and the reserves in the bank.

Required reserve ratio: Required reserve ratio refers to the portion of the total money deposits that is collected by the banks. This amount cannot be used for further lending or investing purpose. The percentage is decided by the Federal Reserve.