Question

Assume the banking system contains the following amounts. Use this information to answer five questions.

Total reserves$30billion

Transactions deposits$300billion

Cash held by public$400billion

Reserve requirement0.1

Instructions: Enter your responses rounded to the nearest whole number.

a. Are the banks fully utilizing their lending capacity?

• Yes

• No

b. What would happen to the money supply initially if the public deposited $20 billion of cash in transactions accounts?

• No change

• Increase by $20 billion

• Decrease by $20 billion

• More information is needed

c. What would the lending capacity of the banking system be after this deposit?

     $  billion

d. How large would the money supply be if the banks fully utilized their lending capacity?

     $  billion

e. What three policy tools could the Fed use to offset that potential growth in M1?

Answer 1

Solution:-

(a) Transaction deposits = $300 billion

Total reserves = $30 billion

Reserve requirement = 0.1

Required Reserve = 0.10 * $300 billion

                              = $30 billion

The required reserves are equal to the total reserves. This indicates that banks do not have any excess reserves and, thus, are utilizing their lending capacity to the full.

The answer is yes, the banks are fully utilizing their lending capacity.

(b) There would be no change in the money supply.

(c) New deposit = $20 billion

Reserve requirement = 0.1

Required reserve created by this new deposit = New deposit * reserve requirement

                                                                         = $20 billion * 0.1

                                                                        = $2 billion

Excess reserves created by this new deposit = New deposit - required reserves created

                                                                        = $20 billion - $2 billion

                                                                        = $18 billion

Thus, this new deposit will create excess reserves of $16 billion with banks.

Banks can lend the excess reserves they held.

So,

Total increase in lending capacity of banks = Excess reserves created * (1/reserve requirement)

                                                                   = $18 billion * (1 / 0.1)

                                                                   = $18 billion * 10

                                                                  = $180 billion

Thus, The lending capacity of the banking system after this deposit would be $180 billion.

(d) Calculate the total money supply:-

Total money supply = Initial transaction deposits + Initial cash held by public + Increase in lending capacity

= $300 billion + $400 billion + $180 billion

= $880 billion

(e) The three potential tools that Fed can use to offset the potential growth in M1 -

1. Raise the reserve requirement

2. Raise the discount rate

3. Conduct open market sale