Question

Assume that the following data describe the current condition of the commercial banking system:

TOTAL RESERVES: $20 billion

Transactions deposits: $400 billion

Cash held by public: $300 billion

Required reserve ratio: 0.05

a. How large is the money supply (M1)? ___________

b. Are the banks fully utilizing their lending capacity?

- Banks currently have _____ billion in excess reserves.

Now assume that the public deposited another $10 billion in cash in transactions accounts.

c. What would happen to the money supply initially (before any lending takes place)?

Assuming the $10 billion in cash is not new money in the system, M1 will _____ (not change)

d. How much would the total lending capacity of the banking system be after this portfolio switch? ____ billion

e. How large would the money supply be if the banks fully utilized their lending capacity? ___ billion

Answer 1

(a)

Calculate M1 money supply -

M1 = Transaction deposits + Cash held by public

M1 = $400 billion + $300 billion

M1 = $700 billion

The money supply (M1) is $700 billion.

(b)

Transaction deposits = $400 billion

Required reserve ratio = 0.05

Required reserves = Transaction deposits * Required reserve ratio = $400 billion * 0.05 = $20 billion

The required reserves with banking system are $20 billion.

The total reserves with banking system are $20 billion.

Since, total reserves are equal to required reserves, there are no excess reserves with banking system.

Thus,

Banks currently have $0 billion in excess reserves.

(c)

Cash held by public and transaction deposits are part of M1 money supply.

So, deposit of $10 billion cash in bank will reduce the cash by $10 billion and will increase transaction deposits by $10 billion.

This will keep the M1 unchanged.

Thus,

M1 will not change.

(d)

New deposits = $10 billion

Required reserve ratio = 0.05

Required reserves created by new deposit = $10 billion * 0.05 = $0.5 billion

Excess reserves created by new deposit = New deposit - Required reserves created by new deposit

Excess reserves created by new deposit = $10 billion - $0.5 billion = $9.5 billion

A bank can lend an amount equal to excess reserves it held.

So,

The total lending capacity of the banking system be after this portfolio switch is $9.5 billion.

(e)

Calculate the total increase in the money supply -

Total increase in the money supply = Increase in lending capacity * [1/required reserve ratio]

Total increase in the money supply = $9.5 billion * [1/0.05] = $190 billion

Thus,

The money supply would increase by $190 billion, if the banks fully utilized their lending capacity.