The money supply contraction process Suppose First Main Street Bank, Second Repu

Question

The money supply contraction process Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 25%. Brian, a client of First Main Street Bank, suddenly withdraws $1,800,000 and purchases Treasury bills from the Fed. The Fed then destroys the $1,800,000. On the assets side of First Main Street Bank's balance sheet (before the bank makes any new loans), this First Main Street Bank's by. On the liabilities side of First Main Street Bank's balance sheet, this First Main Street Bank's by Because the required reserve ratio is 25%, the $1,800,000 withdrawal First Main Street Bank's required reserves by In order to maintain the required reserve ratio, First Main Street Bank now must Now suppose Crystal repays her loan of $1,350,000 to First Main Street Bank by writing a check issued by Second Republic Bank. First Main Street Bank uses funds from a loan repayment to increase its reserves instead of making new loans. Second Republic Bank then replenishes its reserves by using the funds from loan repayments by Jim, who writes a check issued by Third Fidelity Bank. Third Fidelity Bank then uses a loan repayment from Janis to replenish its reserves instead of making new loans. Fill in the following table to show the effect of this ongoing chain of events at each of the banks, including the initial withdrawal at the beginning of the question. Enter each answer to the nearest penny. Assume this process continues, with each successive loan being repaid using a checking account and banks using repayments to replenish their reserves without issuing any new loans. Under these assumptions, the initial destruction of $1,800,000 by the Fed caused banks to reduce their outstanding loans by, resulting in an overall decrease of in checkable deposits.

Explanation / Answer

(a) On asset side, this decreases bank's reserves by $1,800,000 and on liabilities side, decreases checkable deposits by $1,800,000.

(b) The withdrawal decreases required reserves by $450,000 (= $1,800,000 x 25%). So, the bank must increase its reserves by $1,350,000 (= $1,800,000 - $450,000). One possible way is to decrease outstanding loans.

(c)

Decrease: Deposit

Decrease: Required reserve

Decrease: Loan

First bank

$1,800,000

$450,000

$1,350,000

Second bank

$1,350,000

$337,500

$1,012,500

Third bank

$1,012,500

$253,125

$759,375

(d) This causes banks to reduce outstanding loan by $5,400,000 [= $1,800,000 x 0.75 / 0.25], resulting in overall decrease of $7,200,000 (= $1,800,000 / 0.25) in checkable deposits.

Decrease: Deposit

Decrease: Required reserve

Decrease: Loan

First bank

$1,800,000

$450,000

$1,350,000

Second bank

$1,350,000

$337,500

$1,012,500

Third bank

$1,012,500

$253,125

$759,375

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