Question

Use a hypothetical balance sheet to explain why a single commercial bank is able to safely lend an amount equal to its holdings of excess reserves. Further, explain why the banking system can in effect create ‘new reserves’ in an amount that is some multiple of the initial level of excess reserves. What makes this possible and what role does the so-called ‘money multiplier’ play in this analysis? Lastly, if the reserve requirement regulation was abolished, what impact would this have on individual and collective bank money creation?

Answer 1

A commercial is described as a factor of credit which is able to multiply loans and investments and have deposits. With the cash in reserve and deposits, banks create credits. An increase in bank credit means the multiplication of bank deposits. Banks can create credit by giving loans and purchasing securities.

Suppose Mr. X who is a government employee gets his pay cheque of $100.Let us assume Mr. X has an account in Bank A in which he deposits the cheque. Bank A gets the amount of $100 after cheque clearance and the deposits increase by $100. The Balance Sheet of Bank A will appear as follows

Balance sheet Bank A

Liabilities	Assets
Deposits of X +100	Cash +100
Deposit of Z +90	Loan (Z) +90
Total +190	Total +190

Let Z who has borrowed $90 issues a cheque of $90 to R from whom he has purchased goods. Let R deposits the cheques in his account with Bank B.

Balance sheet Bank A

Liabilities	Assets
Deposits +100	Cash +10
	Loan +90
Total +100	Total +100

Balance Sheet Bank B

Liabilities	Assets
Deposit +90	Cash +90
Total +90	Total +90

Cash of Bank B increases because it has collected from Bank A. The total deposits in the banking system now are $190. Bank B will keep aside the 10% as a reserve and will lend out the remaining amount. So it will grant a loan of $81. This will continue and the credit keeps on increasing in the financial system

So it will increase like 100 + 90 + 81 + 72.90 + ....

This is a geometric series and the sum will be 100/0.10 = 1000

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