7. The money creation process Suppose First Main Street Bank, Second Republic Ba

Question

7. The money creation process

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 20%. The Federal Reserve buys a government bond worth $1,500,000 from Nick, a client of First Main Street Bank. He deposits the money into his checking account at First Main Street Bank.

Complete the following table to reflect any changes in First Main Street Bank's T-account (before the bank makes any new loans)

Complete the following table to show the effect of a new deposit on excess and required reserves when the required reserve ratio is 20%.

Hint: If the change is negative, be sure to enter the value as negative number.

Now, suppose First Main Street Bank loans out all of its new excess reserves to Latasha, who immediately uses the funds to write a check to Jake. Jake deposits the funds immediately into his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Nick, who writes a check to Rosa, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new excess reserves to Alyssa as well.

Fill in the following table to show the effect of this ongoing chain of events at each bank. Enter each answer to the nearest dollar.

Assume this process continues, with each successive loan deposited into a checking account and no banks keeping any excess reserves. Under these assumptions, the $1,500,000 injection into the money supply results in an overall increase of ___?___ in demand deposits.

Assets Liabilities Reserves/deposits/net work/loans Reserves/deposits/net work/loans

Explanation / Answer

When Nick will deposit $1,500,000 in his Checking account at First Main Street Bank then in that case Checking deposits as well as reserves at First Main Street Bank will increase by $1,500,000.

Reserves are taken on assets side while Checkable deposits are taken on liabilities side.

So, complete T-account of First main Street Bank after this transaction is as follows -

Assets

Liabilities

Reserves

$1,500,000

Checkable deposits

$1,500,000

Required reserve ratio is 20%. This means out of its total reserves, First main Street bank has to kept 20% of its deposits either at its vault or deposit them with Fed.

So, complete table is as follows –

Amount Deposited

Change in excess reserves

Change in required reserves

(Dollars)

(Dollars)

(Dollars)

1,500,000

1,200,000

300,000

Total excess reserves at First Main Street Bank are $1,200,000. So, it will make a loan of $1,200,000 to Jake.

Jake deposits this amount at Second Republic Bank.

So, deposits at Second Republic bank will increase by $1,200,000.

With required reserves ratio of 20%, Second republic Bank will keep $240,000 as required reserves and $960,000 ($1,200,000 – $240,000) will be its excess reserves.

Total excess reserves at Second Republic Bank are $960,000. So, it will make a loan of $960,000 to Nick.

Nick writes a check to Rosa.

Rosa deposits this amount at Third Fidelity Bank.

So, deposits at Third Fidelity bank will increase by $960,000.

With required reserves ratio of 20%, Third Fidelity Bank will keep $192,000 as required reserves and $768,000 ($960,000 – $192,000) will be its excess reserves.

Total excess reserves at Second Republic Bank are $768,000. So, it will make a loan of $768,000 to Alyssa.

Complete Table is as Follows –

Increase in Deposits

Increase in Required Reserves

Increase in Loans

(Dollars)

(Dollars)

(Dollars)

First Main Street Bank

1,500,000

300,000

1,200,000

Second Republic Bank

1,200,000

240,000

960,000

Third Fidelity Bank

960,000

192,000

768,000

Total

3,660,000

732,000

2,928,000

As above table shows that with each successive loan deposited into a checking account and no banks keeping any excess reserves, the $1,500,000 injection into the money supply results in an overall increase of $3,660,000 in demand deposits.

Assets

Liabilities

Reserves

$1,500,000

Checkable deposits

$1,500,000

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