Question

A bank currently has $70,000 in deposits, $6,000 in cash in the vault, $12,000 on deposit with the Fed, and $7,000 in government securities. The required reserve ratio is 20 percent. Answer these questions:

1) What is the maximum amount the money supply can increase, assuming this bank is the only bank in the system that has excess reserves?

2) An individual deposits a $750,000 check into the bank. That individual had just converted foreign currency into dollars so the $750,000 was not in the money supply before the deposit. What is the maximum size loan the bank can make once the check clears?

3) What is the maximum amount the money supply can increase as a result of the $750,000 deposit?

4) If these expansions in the money supply happen, what effect will it have on aggregate demand, GDP, and employment?

5) What could keep the expansions from happening?

Answer 1

Question 1

Deposit = 70000

Required reserve ratio (rr) = 20% or 0.20

Money multiplier = 1/rr = 1/0.20 = 5

Required reserves = Deposits * rr = 70000 * 0.20 = 14000

Total reserves = cash in vault + deposits with the Fed

Total reserves = 6000 + 12000 = 18000

Excess reserves = Total reserves - Required reserves = 18000 - 14000 = 4000

Maximum increase in money supply = Excess reserves * money multiplier = 4000 * 5 = 20000

The money supply can increase by a maximum amount of $20,000.

Question 2

New deposit = 750000

Required reserves = 750000 * 0.20 = 150000

Excess reserves = 750000 - 150000 = 600000

The maximum size loan the bank can make once the check clears is $600,000.

Question 3

Maximum increase in money supply = New deposit * money multiplier = 750000 * 5 = 3750000

The maximum amount by which money supply will increase is $3,750,000.

Question 4

Expansion in money supply will lower the interest rate.

This will increase the consumption and investment spending backed by credit.

Increase in these two will lead to increase in aggregate demand which in result will lead to increase in GDP and employment.

Question 5

Two factors can keep expansions from happening -

1. Banks do not lend the entire excess reserves at their disposal.

2. Consumers and businesses do not borrow as assumed even if interest rate falls.