Question

Initially, the Republic of Gorgonzola has no commercial banking system. To make trading easier and eliminate the need for barter, the government directs the central bank of Gorgonzola to put into circulation 4,000,000 identical paper notes, called guilders. The central bank prints the guilders and distributes them to the people. At this point the Gorgonzolan money supply is 4,000,000 million guilders.

In order to keep the money safe, some Gorgonzolan entrepreneurs set up a system of commercial banks. When people need to make a payment, they can either withdraw their guilders or 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 earn 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 4,000,000 guilders into circulation and (2) commercial banks desire to hold reserves of 25 percent of deposits. Assume that the public holds no currency.

Instructions: Enter your responses as whole numbers.

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

Initial balance sheet

Assets		Liabilities
Currency	4,000,00	Deposits 4,000,00

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)	1,000,00	Deposits	4,000,00
Loans	3,000,00

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

Balance sheet after redeposits

Assets		Liabilities
Currency (= reserves)	4,000,00	Deposits	8,000,00
Loans	4,000,00

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)	4,000,00	Deposits	11,200,00
Loans	7,200,00

e. The final values of bank reserves, loans, deposits are:

Final consolidated balance sheet

Assets		Liabilities
Currency Final value of bank reserves	(=11,200,00	Deposits	11,200,00
Loans	28,000,00

               
The final value of the money supply is: 11,200,00 guilders.     

Answer 1

Solution:-

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

Initial balance sheet

Assets		Liabilities
Currency	40,00,000	Deposits 40,00,000

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

The central bank holds 25 percent of total deposits as reserve and remaining amount given as a loan.

Reserve = 25% * 40, 00,000 = 10, 00,000

Loan = 30, 00,000 (40, 00,000 - 10, 00,000

Balance sheet after first round of loans

Assets		Liabilities
Currency (= reserves)	10,00,000	Deposits	40,00,000
Loans	30,00,000

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

Balance sheet after redeposit

Assets		Liabilities
Currency (= reserves)	40,00,000	Deposits	70,00,000 ( initial deposits of 40,00,000 + loan of 30,00,000)
Loans	30,00,000

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

The bank will lend 80% of total deposits and reserve will be the same

The Loan = 75% * 70, 00,000 = 5250000

Deposits will be 92, 50,000 (52, 50,000 + 40, 00,000)

Balance sheet after second round of loans and redeposit

Assets		Liabilities
Currency (= reserves)	40,00,000	Deposits	92,50,000
Loans	52,50,000

e. The final values of bank reserves, loans, deposits are:

Money supply = (1/CRR) * reserve

                         = 4 * 40, 00,000

                         = 160, 00,000

Loans = 75% * 160, 00,000 = 120, 00,000

Currency = 25% * 160, 00,000 = 40, 00,000

Final consolidated balance sheet

Assets		Liabilities
Currency Final value of bank reserves	40,00,000	Deposits	160,00,000
Loans	120,00,000

               
Money supply = (1/CRR) * reserve

                       = 4 * 40, 00,000

                       = 160, 00,000