Question

Assume the required reserve ratio is 5%, and a bank’s excess reserves are $50 million.

Which of the following accurately explain why checkable deposits resulting from new loans based on excess reserves are not likely to generate the maximum of $50 million×20=$1,000 million$50 million×20=$1,000 million? Check all that apply.

Cash leakage increases the value of the money multiplier.

Cash leakage reduces the value of the money multiplier.

Banks not using all their excess reserves to make loans increases the value of the money multiplier.

Banks not using all their excess reserves to make loans reduces the value of the money multiplier.

Answer 1

Bank create money supply via money multiplier by using the funds they have with them multiple times to make loans. Since the amount underlying the loans also stays with the banks in the form of a deposit (checkable or time), banks use this again to make fresh loans and so on. The process could go on for infinite number of times, but each new loan would be of a smaller amount since the banks need to keep a reserve which is a requirement specified by the central bank.Money multiplier is equal to 1/required reserve ratio, so in this case it will be 1/5% = 20 times of initial deposit.

Now if a bank keeps excess reserves, say 10% instead of 5%, their ability to create money will go down. Their money multiplier would only be 1/10% = 10 times of initial deposit. As explained above, you can see that this happens becauase for each successive loan they keep 10% aside in the form of reserve, instead of 5%.

Hence the right answer is teh fourth option: Banks not using all their excess reserves to make loans reduces the value of the money multiplier.