Suppose the Bank of Canada (BOC) buys $10B worth of bonds from the Canadian banking system...

Suppose the Bank of Canada (BOC) buys $10B worth of bonds from the Canadian banking system that operates with a desired reserve ratio of 5%. Immediately after the transaction, the balance sheet of the BOC expands by $10B, while balance sheet of the banking system is the same size, but in the long run, the balance sheet of both the BOC and the banking system expand by $200B. is this statement true false or uncertain, explain. unsupported answers will receive no marks

Expert Solution

ANSWER: FALSE

When the BOC purchases $10B of bonds the Balance sheet will show no change at all. The reason for the same is debit investment for $10B and credit cash for $10B. On the other hand balance sheet of the banking system will expand by $10B as reserves are debited for $10B and deposits are credited by $10B in liability account.

Banking system ratio was 5% after purchasing it has been changed to 36% ($11B/$30B). The desired reserve ratio for banking system is 5% ratio than 5% of $30B is $1.5B.

Excess reserve with 30 B in deposits ($9.5B (11B – 1.5B)

Assuming that banking system can lend all of the $9.5B which will in turn increase the loan amount by $9.5B but cash reserves are reduced by the same amount.

The formula 1/v could be used (V is the target reserve ratio which is 5% or 0.05), if the bank continue to loan.

1/0.05 =20.

So now we can say that total deposits in the banking system will eventually increase by 20 times which is $10B x 20 = $200B.

From the above we can conclude that balance sheet of the banking system will expand by $200B in the long-run.

Rahul Sunny answered 2 years ago

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