Question

1. Using these three terms, write a sentence to describe the role of the Third National Bank in the money creation process. (Demand Deposit--Legal Reserve—Excess Reserves)

2. Mrs. Jones decides to flip her mattress one day and discovers $1000 in the process. She decides to take that $1000 to the Third National Bank and makes a deposit. The Required Reserve Ratio from the Federal Reserve Bank is 20%. Explain the amount of new money that can be created by Third National Bank, solely, after the Jones deposit.

3. Explain why the Jones deposit can lead a greater increase in the money supply, considering the entire networks of banks, than what can happen at the Third National Bank. Keeping in mind that the reserve requirement is 20%, and banks wish to lend all excess reserves, how much money can be created for the money supply from the initial $1000 deposit?

4. Discuss two situations that can occur to reduce the growth of the money supply in this process.

5. Explain the net export effect in relation to an easy money policy. How does the net export affect differ in an easy money policy compared to a fiscal policy designed to increase demand?

Answer 1

After the money deposited in bank, the bank needs to keep only the required reserve and create additional claims on the remaining amount. Money created = (1-0.8)*1000 = 800

Considering the entire network of banks, considering person x took the amount 800 and deposits in his bank A, bank A will lend excess reserves creating (1-0.2)*800 = $640
Person Y taking this amount and depositing in bank B, bank B will lend excess reserves creating (1-0.2)*640 = $480
This process will be followed across the banking network
Total money created = 1000/0.2 = 5000

2 situations are if the people use more of the amount as cash rather than depositing the money in bank leading to lesser amount available to the banks for money creation. Other situation is if banks hold on to excess reserves due to risk aversion slowing money supply.

Net export effect is the change in net exports (exports-imports) from foreign investors responding to a change in interest rate or price level that alters the relative price of exports and imports. An easy monetary policy leads to increased domestic spending and increased GDP due to lower rates and higher lending (economic activity). Further this also leads to depreciation of domestic currency and higher export demand, which enhances GDP reducing a trade deficit. Therefore, this policu reduces both trade deficit, on the other. A fiscal policy designed to increase demand can however have no/ negtive impact on the trade deficit as higher govt borrowing may increase the rates leading to increase capital flows, domestic currency appreciation and reduced export demand.