A bank currently has $700,000 in deposits, of which $60,000 is in cash in the va
ID: 1225502 • Letter: A
Question
A bank currently has $700,000 in deposits, of which $60,000 is in cash in the vault, $120,000 is on deposit with the Fed, $70,000 is held in government securities, and the rest has been loaned out. The required reserve ratio is 20 percent. Answer these questions: 1) If the bank has excess reserves, what is the maximum amount the money supply can increase when they are loaned out (also assuming this bank is the only bank in the system that has excess reserves)? For questions 2-5, assume the bank is operating with no currently existing excess reserves. 2) An individual deposits a $750,000 check into the bank. That individual had just converted foreign currency into dollars so the $750,000 was not in the money supply before the deposit. What is the maximum size loan the bank can make once the check clears? 3) What is the maximum amount the money supply can increase as a result of the $750,000 deposit? 4) If these expansions in the money supply happen, what effect will it have on aggregate demand, GDP, and employment? 5) What could keep the expansions from happening?
Explanation / Answer
Question 1
Total deposits with bank = $700,000
Required reserve ratio = 20% or 0.20
Required reserves = Total deposit * required reserve ratio
= $700,000 * 0.20
= $140,000
Total reserves = Cash in vault + Deposit with Fed
= $60,000 + $120,000
= $180,000
Excess reserves = Total reserves – Required reserves
= $180,000 - $140,000
= $40,000
Money multiplier = 1/Required reserve ratio
= 1/0.20
= 5
If bank loaned out all its excess reserves then,
Maximum increase in money supply = Excess reserves * Money multiplier
= $40,000 * 5
= $200,000
The maximum amount of increase in money supply is $200,000.
Question 2
New deposits with bank = $750,000
Required reserve ratio = 20% or 0.20
Required reserves = New deposit * required reserve ratio
= $750,000 * 0.20
= $150,000
Excess reserves = New deposit – Required reserves
= $750,000 - $150,000
= $600,000
A bank can lend at maximum an amount equal to quantum of excess reserves it held.
The total excess reserves bank had after this new deposit is $600,000.
Thus, the maximum loan that bank can make once the check clears is $600,000.
Question 3
Excess reserves created by new deposit = $600,000
Money multiplier = 5
Maximum increase in money supply = Excess reserves created by new deposit * Money multiplier
Maximum increase in money supply = $600,000 * 5 = $3,000,000
The maximum increase in money supply as a result of the $750,000 deposit is $3,000,000.
Question 4
If expansion as stated in question 3 happens then such increase in money supply will result in fall in interest rate. This fall in interest rate will reduce the cost of borrowing and would induce the households and firms to borrow. So, households and firms will borrow more for consumption and investment demand. Both consumption and investment are component of aggregate demand. So, increase in these two will increase the aggregate demand.
Given the short-run aggregate supply, this increase in aggregate demand will result in increase in GDP.
Increase in GDP implies increase in production which in result will create more jobs and thereby employment.
So, if these expansions in money supply happen then such expansions in money supply will lead to increase in aggregate demand, GDP, and employment.
Question 5
It is when bank loaned out the excess reserves that the money supply expands and result in increase in aggregate demand, GDP, and employment. If bank instead of dispensing excess reserves as loan keep them with itself then in such case there will be no further expansion in money supply (apart from first increase in money supply as a result of new deposit).
So, if bank keeps the excess reserves created by new deposit with itself instead of loaning them out, it can keep the expansions from happening.
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