Question

2. A commercial bank has deposits of $100,000 and total reserves of $31,000. The required reserve ratio is 15%. All other banks are fully loaned up.

1. Show this bank’s balance sheet.
2. Calculate actual reserves (AR), required reserves (RR), and excess reserves (ER).
3. What is the largest loan this bank can make?
4. If the initial loan is made, what is the maximum expansion of the money supply that can occur if other banks also lend as much as possible?
5. Where did this additional money come from? What “backs” this money?

Answer 1

a)   

Balance sheet of bank

Assets	Liabilities
Total reserves $31,000 Loans $69,000	Deposits $100,000

As deposits of the bank are $100,000 and total reserves are $31,000, the rest of the amount of the deposit is used to make loans.

b) Actual reserves are the reserves which the bank currently has with itself. As the total reserves of the bank are $31,000, it means that the actual reserves (AR) of the bank are $31,000.

Required reserves are a certain percentage of the deposits of the bank which it is required to keep with itself in the form of reserves. These reserves cannot be used by the bank to extend loans and advances. It is calculated as-

Required reserves= deposits x required reserve ratio

Required reserves= $100,000 x 15%

Required reserves= $100,000 x 15/100

Required reserves= $100,000 x 0.15

Required reserves= $15,000

Hence, the required reserves( RR) of the bank are $15,000.

Excess reserves are the reserves which are over and above the required reserves. These reserves are used to make loans and advances. From the above calculations we can see that the actual reserves of the bank ( $31,000) are over and above the required reserves ( $15,000) , which are called excess reserves.

Excess reserves= actual reserves ( AR) - required reserves ( RR)

Excess reserves= $31,000 - $15,000

Excess reserves= $16,000

Hence, the excess reserves( ER) of the bank are $16,000.

c) Required reserves cannot be used by the bank to extend loans. Only excess reserves are used to make loans and advances. As the excess reserves of the bank are $16,000 , the largest loan this bank can make is $16,000.

d)

When a bank lends out it's excess reserves, the amount loaned gets deposited into other banks and the same process of depositing and lending out continue to take place until the last amount deposited is too small to make a loan. The total amount of money generated as a result of an initial deposit made can be calculated as-

New deposits= 1/RR x D

( Where RR is the required reserve ratio and ​​​​D is changechange in Initial deposit)

New deposits= 1/15% x $100,000

New deposits= 1/(15/100) x $100,000

New deposits= 1/0.15 x $100,000

New deposits= 6.7 x $100,000

New deposits= $670,000

The maximum expansion of the money supply is $670,000