Question

Discuss the relationship between the reserve ratio and the maximum money creation. Why is the actual money creation smaller than the maximum money creation implied by the model of multiple-deposit expansion? ( 2 points )

Answer 1

Maximum Money creation= (1÷Reserve Ratio)× Monetary Base.

Thus, Maximum money created by a commercial bank is equal to Reciprocal of Reserve Ratio multiplied by Monetary Base. As, Reserve Ratio decreases, maximum money that commercial banks can create, increases and Vice versa. This is due to Fractional reserve system wherein only a part of deposits is to be kept by the bank as reserves and rest it loans out such that value of Reserve is less than the claims outstanding on those reserves through amount loaned out. Thus Maximum money created depends on how much part of total deposit(or Monetary base) bank Bank has to keep with themselves as required by Reserve Ratio.

Actual money creation may be smaller than maximum money creation because banks may keep excess reserves with them. Banks keep excess reserves with themselves when they want to loan out little as there may ne no profitable opportunities available. This keeping of excess reserves reduces the money creation.