Question

Suppose Never Bank (not the central bank), operating in (fictitious country) Neverland holds $100 million in deposits. Also assume that banks in Neverland are supposed to maintain the (required) reserve ratio of 10%.

1. Assume initially that Never Bank is the only bank in Neverland. State the effects on money supply if Never Bank decides not to make any loans. Compare this to the effect on money supply if, alternatively, Never Bank decides to loan out all its available deposits for loans. (compare both the scenarios in 150 words or less).

Answer

2. What will be the effect on money supply if many banks start to open and operate in Neverland and they loan out all their available deposits. (explain in 100 words or less)

        Answer

3. Go back to the scenario presented in Part a, where Never Bank is the only bank in Neverland. Suppose, people of Neverland decide to withdraw their deposits with the Never Bank and keep their money with them as currency. What is the quantity of money in Neverland in this situation? State the assumption you made here. Compare the quantity of money in this situation with the one in ‘Part a’ where the Never Bank does not make any loans out of its deposits. (answer each in 50 words or less)

Answer

Answer 1

Given information:

• Reserve requirement = 10%
• Initial deposit = $100 million

Money supply vs lending:

Zero loan:

• Received deposit = $100 M
• Reserve ratio = 10%
• Available loanable fund = Received amount x (1 - Reserve ratio) = $100 M x (1 - 10%) = $90 M

If the Never bank does not make any loans, the money supply would have $90 M and will not increase. Compared to the available of cash of $100M, the money supply is now only $90, which is reduced $10M by the reserve requirement.

All available funds are pumped into the economy:

Moneymultiplier=1Reserveratio=110%=10Moneymultiplier=1Reserveratio=110%=10

The money supply will increase by 10 times if the Never Bank lends out all of $90 M to other entities in the economy.

To demonstrate how the money supply is increased, follow the below rules:

• Never bank receives $100M and lends out $90M to other entities. $10M will go the reserve account in the central bank.
• Other entities receive $90M and deposit $90M to Never Bank.
• Never bank receives $90M and lend out $81M to the economy. $9M will go to the reserve account in the central bank.

At this point, the total money notes in the economy, include the money in the reserve account, is only $100M. However, the money in the banking system is addressed as below:

• Available money in the economy = $90M + $81M = $171
• Reserve account = $10M + $9M = $19M