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%.

a) 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.

b) 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)

c) 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 1

a) Considering that the loans issued or provided by commercial banks and other financial institutions to individuals, households, and firms or businesses from their excess reserves increases the overall or total liquidity or financial flow in the economy, the decision of the Never Bank not to provide any financial loan would the overall money supply would be equal to the total checkable deposits held by the bank, holding everything else constant. In this case, the total checkable deposits held by Never Bank is $100 million and the minimum reserve ratio is 10% or 0.1. Therefore, the total required reserve of Never Bank=(0.1*$100 million)=$10 million. Hence, Never Bank can provide loans from its excess reserve of=($100 million-$10 million)=$90 million.Since, it does not provide any loan the total money supply in the concerned economy would be $100 million. On the other hand, based on the same line of argument, if the Never Bank decides to loan out all its excess reserves to the customers or financial borrowers, the overall liquidity or financial currency circulation in the concerned economy would increase by $90 million and the excess reserve would be equal to the total or overall deposit held by the bank which is $10 million. Note that, in this case, the total money supply in the concerned economy would be=$90 million+$10 million=$100 million.

b) Now, in general, if other banks open their branches in Neverland aside from Never Bank and start to loan out their excess reserves, the overall or total money supply in Neverland economy would increase. In this regard, it can be reasonably assumed that as more banks starts to open in the country, they would increasingly gain customers who would deposit their financial assets and money into those banks thereby increasing the checkable deposits of other banks in Neverland aside from Never Bank. Now, holding the initial total deposits of Never Bank as constant, this would increase the total or overall money supply in Neverland as increase in total checkable deposits in the economy would lead to an increase in the total money supply, holding everything else as constant.

c) Considering again that Never Bank is the only bank in Neverland and the people in Neverland decides to withdraw their deposits from the bank, the total money in circulation would now become $100 million in Neverland economy and the deposit of the bank would become 0, assuming that the entire initial deposit of Never Bank has been withdrawn and there are no banks in Neverland and any initial amount of money in circulation in the economy. Now, comparing to part a) of the question, in this case, the total checkable deposit in Neverland economy becomes 0 assuming Never Bank is the only bank in the country and the total money in circulation becomes $100 million and the total money supply in the Neverland economy remains=($100 million+$0)=$100 million. In part a) of the question the total checkable deposit of Never Bank remained $100 million and the total money in circulation was $0 as Never Bank, which was the only bank in Neverland decided not to provide any loan from its total excess reserve and the total money supply based on part a) of the question was=($0+$100 million)=$100 million.