Question

1. In ancient times money was normally created by government. However, under the modern banking system in the U.S. and other developed countries, money is normally created by Banks. The process begins when a depositor brings, let’s say, $100 in currency into the bank for deposit. The bank accepts the deposit and creates a Demand Deposit (DD) for the customer in the amount of $100. The bank now has $100 in liquid funds it did not have before. As discussed in class, there are three things the bank can do with this new money: 1) It can keep the money as Vault Cash (a lot of it inside of ATM machines), 2) It can place the money on deposit at the Federal Reserve Bank (Fed) to be held as Reserves, 3) It can purchase securities for the bank’s securities portfolio. Let’s say that the bank places the entire $100 on reserve at the Fed. Answer these questions:
2. 1. At this point, what change has taken place in the Total M1 Money Supply in the economy?
   2. At this point, what change has taken place in the Bank’s Total Reserves?
   3. At this point, what change has taken place in the Bank’s Excess Reserves?
   4. How much new money can the bank now lend out in the form of Demand Deposits?

Answer 1

As the bank has received new money from a customer in the form of deposit, there is an increase in its total liabilities.

1. The total money supply in the economy has decreased by $100, as the money has been placed with Federal Reserve, and is not being used by bank for lending.
2. Total Reserves of the bank include the reserves it has in its vault, along with the money it has with the Fed, to cover its immediate liabilities. Now, as the money with the Fed, Total Reserves have increased by $100.
3. Excess reserves is defined as the portion of deposits remaining with the bank which is left out by deducting the Required Reserve from Total Deposit. Here, the total deposit into the bank has been kept as a reserve in Fed, so, the Excess Reserves is changes by Zero.
4. The banks can lend out the same amount of money it can lend in the form of DD as the total deposit goes into Fed and nothing is left with bank in its Vault.