Question

Andy deposits $1000 into his checking account at First National Bank.

a). What happened to M1 (narrow money supply)?

b). How does First National T-accounts change after Andy’s deposit?

c.) Banks in this economy like to keep 10% of deposits in reserves. How does First National change its T-account?

d.) The loans that First National Bank makes are spent and sellers deposit their proceeds in their checking accounts. Suppose this process goes on many, many times. What will be the total amount of checking deposits after many many rounds?

e.) What will have happened to the narrow money (M1) at the end of these rounds? Give numerical answer.

Answer 1

A. Narrow money supply includes all the liquid money in the economy- such as coins, currencies and deposits. Hence, when Andy deposits $1000 in his checking account, narrow money supply in the economy increases by $1000.

B. First national's assets will lise by $1000, but so will its liabilities + net worth. The change in its T-accounts are shown below.

C. It will add 10% of 1000=100 in asset side as a reserve entry. That is shown below. The rest 900 it is free to loan out.

D. This is called money multiplier. There is only one deposit but each bank keeps aside the reserve and loans the rest. The other bank does the same and so forth. The total amount of checking deposits after this process happens many many times (that is, infinite) is given by

(1/reserve requirement)*excess deposits

In this case excess deposits at the first step were 900 dollars, so

Increase in deposits=900/.1=9000.

e. Assuming all funds generated this way were deposited into checking accounts only, as the question states, the Narrow money supply is now up by 9000 dollars.