Question

Showing How Banks Create Money

Suppose you deposit​ $5,000 in currency into your checking account at a branch of PNC​ Bank, which we will assume has no excess reserves at the time you make your deposit. Also assume that the required reserve ratio is 0.10.

a. Use a​ T-account to show the initial effect of this transaction on​ PNC's balance sheet.

b. Suppose that PNC makes the maximum loan it can from the funds you deposited. Use a​ T-account to show the initial effect on​ PNC's balance sheet from granting the loan. Also include in this​ T-account the transaction from question​ (a).

c. Now suppose that whoever took out the loan in question​ (b) writes a check for this amount and that the person receiving the check deposits it in Bank of America. Show the effect of these transactions on the balance sheets of PNC Bank and Bank of America after the check has cleared.

On the​ T-account for PNC​ Bank, include the transactions from questions​ (a) and​ (b).

d. What is the maximum increase in checking account deposits that can result from your​ $5,000 deposit? What is the maximum increase in the money​ supply? Explain.

Answer 1

a) When an initial deposit is made for $5,000 at PNC Bank with no excess reserves, at this stage PNC bank just stores all the money of the depositors following a 100% reserve system. Here no loans are made. Thus the assets as reserves & the liability of the bank is equal to $5000.

PNC
Assets	Amt	Liabilities	Amt
Reserves	$5,000	Checkable Deposits	$5,000

b) PNC bank is required to keep 10% (fractional reserve system) of the total deposits as reserves, which is $500. Then the maximum amount which the bank can loan and earn interest is $ 5000 - $ 500 = $ 4500. While loaning up an amount of $4500, the bank is able increase money supply by $4500 in the economy. The T-account of PNC bank below shows:

PNC
Assets	Amt	Liabilities	Amt
Reserves	$500	Checkable Deposits	$5,000
Loan	$4500

In this roundm the bank is able to create additonal money equal to $4500, hbut the deposits with it remains $5000.

c) Now somebody who took the loan from PNC bank writes a check of the respective loan amount. If the receiver of the check deposits that in Bank of America, then the checkable deposits comes out to be equal to $4500. With reserve ratio of 10%, Bank of America keeps a reserved amount of $450 and is able to lend maximum $ 4500 - $ 450 = $ 4050 as loans. With this loan, the bank is able to increase the money supply further by $4050 in the economy. The T-account for Bank of america after the check gets cleared is given below :

Bank Of America
Assets	Amt	Liabilities	Amt
Reserves	$450	Checkable Deposits	$4500
Loan	$4050

d ) In fractional reserve system banking with multiple banks, given the required reserve ratio - the banks will keep on creating new money and increasing money supply till the time no more money is left to be either deposited or loaned out. Thus the new money created can calculate by the initial amount of deposit, which is $5000 in our case.

New Money Created = Initial Deposit / Required Reserved

New Money Created = 5000 / 0.10

= $50000 (Increase in Money Supply)

Where, I / RR = Money Multiplier, i.e. the fraction by which the deposits and the money increases in an economy.

In our case, Money Multiplier = 1/0.10 = 10