Question

a) Jane deposited $1,000 in paper currency (50 x $20 bills) into her demand deposit checking account at Chase Bank. Did her deposit change the amount of M1 in the economy, if yes by how much? ( one sentence)

b) The Reserve Requirement is 20%. How much money can Chase Bank lend out after Jane's $1000 deposit? ( one sentence)

c) Given the 20% Reserve Requirement, what is the maximum amount of new M1 that can be created through banks giving out loans as a result of Jane's deposit of her $1,000 in paper currency into her demand deposit checking account at Chase? Explain how this growth in M1 takes place. (5-7 sentences)

d) What is the money multiplier(MM) or demand deposit expansion multiplier(DDEM) if the reserve requirement is

Res. Req. MM/DDEM

1) 5%

2) 10%

3) 20%

4) 25%

Answer 1

a) M1 money supply refers to total value of money available in the economy in the form of currency and demand deposits.

M1 = Currency in Circulation + Demand Deposits

When Jane deposited $1000 in demand deposit checking account at Chase bank, the money supply does not change because the money in one’s pocket is already a part of money supply and so are the deposits.

b) The required reserve ratio specifies the amount of money the banks are required to keep with them as reserves in order to meet any demand for sudden withdrawals. In the fractional reserve banking system, the banks keep a part of the deposits as reserve and lends out the remaining amount that creates new money in the market.

Given the required reserve ratio = 20%, the with Jane’s initial deposits Chase bank keeps 20%of $1000 = $200 as reserves and lends out $1000 - $200 = $800 as loans.

c) Continuing from the above scenario we can explain the money creation process in the below rounds :

Round 1: There is an initial deposit by Jane in his demand deposit account at chase bank. Since Chase bank is required to keep 20% of it’s total deposit as reserves which is $200, it is able to lend out $800 as loans. Thus, by making loans the bank is able to create money of additional $800 in the economy.

Round 2: Suppose an individual say X, borrow $800 from Chase bank and deposits this amount in his own demand deposit account in another bank “A”. Here the deposit of Bank A increases by $800 and as a rule by the central bank, Bank A too is required to keep 20% of its deposits as reserves. So it keeps 20% of $800 = $160 as reserves and loans out $800 - $160 = $640 I the credit market. Thus, Bank A creates additional money of $640 in the economy.

Round 3: The same process keep on repeating in the economy till all the deposits are exhausted and no more money is available to loan out. Thus money supply keeps on increasing with an increase in the demand deposits

Total Money Supply = 1000 + 800 + 640 + ……………. = (1/Required Reserve) * Initial deposits

Where, 1/Require Reserve Ratio = Money multiplier.

Money Multiplier = dMS/dDD = 1/R,   Which is the ratio of the change in money supply due to the change in deposits.  

{ d stands for change }

In our case, with initial deposits of $1000 the total money supply increases to:

MS = (1/0.20) * 1000 = 5*1000 = $5000

However the maximum new money that could be generated in the economy is $5000 - $1000 = $4000. Because the initial $1000 deposits already existed as a part of the money supply.

d) As already explained above money multiplier is the reciprocal of the reserve ratio, i.e.

Money Multiplier = 1/R , where R is the requires reserve ratio

Given R = 20%,

Money Multiplier = 1/0.20 = 5%