Assume all banks have the same reserve requirement, 10% and you just remember yo

Question

Assume all banks have the same reserve requirement, 10% and you just remember you buried $1,000 in your backyard 2 years ago. You take the thousand dollars to your bank and deposit it.

When the rounds have been exhausted, what is the total amount of deposits in the banking system? Show and explain.

Using the total deposit number, show the amount of required reserves created and the amount of loans created by this process.

You will have to think a bit about this one. Using the $1,000 deposit and reserve requirement is still 10%, suppose I tell you that in each round, 10% is withdrawn for cash and this is a leakage. Show and explain what is the multiplier now and what would be total deposits at the end of the process.

From parts ‘a’ and ‘c’, what has happened and why?

What is the size of the FOMC and where do they come from?

Explanation / Answer

When a person deposits Rs. 1,000 with a bank, the bank does not keep the entire cash but only a certain percentage (say 10%) of it to meet the day-to-day cash obligations. Thus, the bank keeps Rs. 100 and lends to another person B, Rs. 900 by opening a credit account in his name. Again, keeping 10% to meet B’s obligations, the bank advances the rest Rs. 810 to C ; further keeping 10% to meet C’s obligations the bank advances Rs. 729 to D and so on, till Rs. 1,000 are completely exhausted.

Thus, an original deposit of Rs. 1,000 leads to additional deposits of Rs. 900 plus Rs. 729 plus and so on. By adding up all the deposits we get total Rs. 10,000. It is clear, therefore, that the total amount of credit creation will be the reverse of the cash reserve ratio. Here cash reserve ratio has been assumed to be 210% or 1/.1, therefore, the credit is Rs. 10,000 i.e., live times the original deposit of Rs. 1,000. Although, we have assumed one bank, yet the credit creation will take place when there are many banks.

Here the money multiplier is 10. (1/RR)

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