(DC1S POINTS) The Fed purchases $100,000 worth of bonds from First National Bank
ID: 1122374 • Letter: #
Question
(DC1S POINTS) The Fed purchases $100,000 worth of bonds from First National Bank Suppose that the required reserve ratio is 20 percent. Answer the following questions. Note: You must show all your work for full credit. Briefly explain your answers as well. (a) (4 POINTS) What is the maximum amount that First National Bank by itself can lend out? (b)(4 POINTS) What is the maximum amount that the banking system.as a whole.can lend out? (c) (7 POINTS) In the real world, why would the total amount of loans made by the banking system as a whole be less than the maximum amount you found in Part (b) above?Explanation / Answer
1.
A.
Excess reserve with the First National Bank (due to the purchase of bond by Fed) is $100000. Since, it is the excess reserve, then full $100000 can be issued as a loan.
Here, the total asset of the bank does not change as the $100000 worth bond is on the asset side of the bank and it is bought by the Fed in lieu of the $100000 cash. So, reserve increases.
B.
Maximum amount of loan to be issued by the banking system = $100000/(Required reserve ratio)
Maximum amount of loan to be issued by the banking system = 100000/20%
Maximum amount of loan to be issued by the banking system = $500000
Loan issued by one bank will be deposited into another bank and it will be reissued as a loan. In total, it will be $500000 as a total loan creation.
C.
In the real world, the total loan creation is less than the answer we have found in part B. It happens due to the many reasons. The first reason is the human tendency to save some money at home. It causes that money, not to go back to the banking system. The second reason is that everyone in the economy is not associated with the banking system. Hence, the leakage of money takes place. The third reason is the tendency of the banks to maintain some excess reserves with themselves so that the urgent needs of the cash as demanded by the depositors can be met on time.
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