Question

Initially, the Republic of Gorgonzola has no commercial banking system. Then, the government directs the central bank of Gorgonzola to put into circulation 2,000,000 identical paper notes, called guilders. The central bank prints the guilders and distributes them to the population. In order to safeguard the money, some Gorgonzolan entrepreneurs set up a system of commercial banks. When people need to make a payment, they can either withdraw their guilders or, more conveniently, write a check on their account. Checks give the banks permission to transfer guilders from the account of the person paying by check to the account of the person to whom the check is made out. With a system of payments based on checks, the paper guilders need never leave the banking system, although they flow from one bank to another as a depositor of one bank makes a payment to a depositor in another bank. Deposits do not pay interest in this economy.

Let’s suppose for now that people prefer bank deposits to cash and so deposit all of their guilders with the commercial banks.

Assume that (1) initially, the Gorgonzolan central bank puts 2,000,000 guilders into circulation and (2) commercial banks desire to hold reserves of 20 percent of deposits. Assume that the public holds no currency.

Instructions: Enter your responses as integer values.

a. The consolidated balance sheet of Gorgonzolan commercial banks after the initial deposits is:

Balance sheet after initial deposits

Assets		Liabilities
Currency		Deposits

b. The consolidated balance sheet of Gorgonzolan commercial banks after one round of loans is:

Balance sheet after first round of loans

Assets		Liabilities
Currency (= reserves)		Deposits
Loans

c. The consolidated balance sheet of Gorgonzolan commercial banks after the first redeposit of guilders is:

Balance sheet after redeposits

Assets		Liabilities
Currency (= reserves)		Deposits
Loans

d. The consolidated balance sheet of Gorgonzolan commercial banks after two rounds of loans and redeposits is:

Balance sheet after second round of loans and redeposits

Assets		Liabilities
Currency (= reserves)		Deposits
Loans

e. The final values of bank reserves, loans, deposits, and the money supply are:

Final consolidated balance sheet

Assets		Liabilities
Currency Final value of bank reserves		Deposits
Loans

               

Money supply:   guilders.

Answer 1

(a)

Gorgonzolan Central Bank has put 2,000,000 guilders into circulation. All this money is deposited into banks.

Following is the consolidated balance sheet of Gorgonzolan commercial banks after the initial deposits -

Assets		Liabilities
Currency	2,000,000	Deposits	2,000,000

(b)

Reserve ratio = 20% or 0.20

Required reserves = Total deposits * Reserve ratio = 2,000,000 * 0.20 = 400,000

Excess reserves = Total deposit - Required reserves = 2,000,000 - 400,000 = 1,600,000

Banks make loan equal to amount of excess reserves they held.

Balancesheet after first round of loans -

Assets		Liabilities
Currency (=Reserves)	400,000	Deposits	2,000,000
Loans	1,600,000

(c)

All loans given will be redeposited into the banking system.

Balance Sheet after redeposits -

Assets		Liabilities
Currency (=Reserves)	2,000,000	Deposits	3,600,000
Loans	1,600,000

(d)

Reserve ratio = 20% or 0.20

Required reserves = New deposits * Reserve ratio = 1,600,000 * 0.20 = 320,000

Excess reserves created by new deposits = Total new deposits - Required reserves created

Excess reserves created by new deposits = 1,600,000 - 320,000 = 1,280,000

Banks make loan equal to the amount of excess reserves they held.

Balance sheet after second round of loans and deposits -

Assets		Liabilities
Currency (=Reserves)	2,000,000	Deposits	4,880,000
Loans	2,880,000