Question

1. Suppose the Fed decides to increase the money supply. It purchases a government bond worth $2,000 from Antonia, a private citizen. Antonia deposits the check in her account at First National Bank. Supposed the required reserve ratio is 0.2 (20%).

(a) Trace the effect of this change through three banks- First National, Second Federal, and Third State.

(b) How much money will be generated in this banking system?

Answer 1

1.

Let suppose here bank keep no excess reserve.

Required reserve ratio= 20%

a.

Fed purchases a government bond worth $2,000 from Antonia and Antonia deposit it into her account in First National Bank. This will cause Rise in deposits at First national bank. Bank will keep 20% of $2000 in reserve and provide remaining amount further as a loan to a person A.

First National bank:

Deposit	Reserve	Loan
$2000	$400 ($2000 x 0.2)	$1600

Now Person A will deposit $1600 in its account in Second federal bank:

Deposit	Reserve	Loan
$1600	$320 ($1600 x 0.2)	$1280

Second federal bank will keep $320 as a reserve and provide $1280 as a loan to Person B.

Now person B will deposit $1280 in its account in Third state bank:

Deposit	Reserve	Loan
$1280	$256 ($1280 x 0.2)	$1024

Third state bank will keep $256 as a reserve and provide $1024 as a loan to some other and this process will continue untill the total reserve in banking system become equals to the initial deposit by Antonia.

b.

Money generated through this Process:

Total Money generated= Money multiplier x Initial deposit

Money multiplier= 1/Require reserve ratio= .1/0.2= 10/2= 5

Initial deposit= $2000

Total Money generated= 5 x $2000= $10000