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

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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 $750,000 from Jake, 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 Frances, who immediately uses the funds to write a check to Dmitri. Dmitri 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 Jake, who writes a check to Latasha, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new excess reserves to Rosa 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 $750,000 injection into the money supply results in an overall increase of   in demand deposits.

Assets Liabilities                

Explanation / Answer

(A) After Jake deposits $750,000 to the bank:

First Main Street Bank's Balance Sheet

Assets

Liabilities

Reserves   

$750,000

Checkable Deposits

$750,000

(B)

Amount deposited

Change in excess reserves ($)

Change in required reserves ($)

750,000

750,000 - 150,000 = 600,000

750,000 x 20% = 150,000

(C)

Bank

Increase in Deposits

Increase in Required Reserves

Increase in Loans

(Dollars)

(Dollars)

(Dollars)

First Main Street Bank

750,000

150,000

600,000

Second Republic Bank

600,000

120,000

480,000

Third Fidelity Bank

480,000

96,000

384,000

(C)

The $750,000 injection in money supply results in overall increase of $3,750,000 (= $750,000 / 0.20) in demand deposits.

First Main Street Bank's Balance Sheet

Assets

Liabilities

Reserves   

$750,000

Checkable Deposits

$750,000

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