Question

The total money supply in an economy is $200 and all of it is in cash form. Then the first bank
opens up (give it any name you like) and the people of the economy go on to deposit $ 200 into
that bank. Incidentally, two other banks open up ( give them any names you like) and the
government then sets up the first Central Bank, which immediately sets down a Reserve Ratio of
20%. With detailed T-Accounts of the three (3) banks explain the procedures through which the
banking system creates money in the economy. Explain all the steps.

Answer 1

Let, the name of the three banks are first bank, second bank and third bank. Here, the deposit of $200 is made to first bank.

When First central bank makes 20% required reserve ratio, then first bank has to maintain 20% of the checking deposit of $200 and rest of the amount is excess reserve in the first bank that can given as loans to other people.

So, required reserve for first bank = 200*20% = $40

Excess reserve with the first bank = 200-40 = $160

It is shown as follows in the T-account of the first bank.

In the next step, first bank issues loan to a person that deposits the funds in second bank. Once the deposit takes place in the second bank, then money creation takes place. Now second bank also has to maintain the required reserve as per the first central bank guidelines. Besides, remaining amount is considered as excess reserve.

So, required reserve for second bank = 160*20% = $32

Excess reserve with the second bank = 160-32= $128

It is shown as follows in the T-account of the second bank.

Now, the second bank issues excess reserve as loan to some other customer as well and that person also deposits it to third bank. This process of lending by second bank, again creates money.

For third bank,

required reserve for third bank = 128*20% = $25.6

Excess reserve with the third bank = 128-25.6 = $102.4

Now, T- Account for the third bank is shown as follows.

So, it can be seen that one bank lending its excess reserve to borrowers and borrowers depositing it to another bank and continuation of same process is creating the money in the economy. It is being done while maintaining the required reserve as mentioned by the first central bank that is 20% in the given example.