Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank al

Question

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 10%. The Federal Reserve buys a government bond worth $500,000 from Paolo, 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 10%. Now, suppose First Main Street Bank loans out all of its new excess reserves to Lucia, who immediately uses the funds to write a check to Kenji. Kenji 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 Paolo, who writes a check to Sharon, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new excess reserves to Amy 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 $500,000 injection into the money supply results in an overall increase of in demand deposits.

Explanation / Answer

Part 1

When Paolo deposits the money into First Main Street Bank, the reserves at the bank increase by $ 500000 while the demand deposits also increase by $ 500000

Asset Side: Reserve Increase $ 500000

Liabilities Side : Demand Deposits Increase $ 500000

Part 2

Amount Deposited : $ 500000

Required Reserves : 10% of amount deposited : $ 50000

Excess Reserves : Amount Deposited - Required reserves = $ 500000 - $ 50000 = $ 450000

Part 3

First Main Street Bank lends all Excess Reserves to Lucia

Thus, First Main Street Bank    Increase in Loan    $ 450000

Lucia gives the same amount to Kenji who deposits it in Second Republic Bank

Thus, Second Republic Bank

Increase in Deposits    $ 450000

Increase in required reserves    10% of $ 450000, i.e, $ 45000

Increase in excess reserves    $ 405000

Second Republic Bank lends its excess reserves to Paolo

Thus,

Second Republic Bank    Increase in loans    $ 405000

Paolo gives the same amount to Sharon who deposits it in Third Fidelity Bank

Thus, Third Fidelity Bank

Increase in Deposits    $ 405000

Increase in required reserves    10% of $ 405000, i.e, $ 40500

Increase in excess reserves    $ 364500

Third Fidelity Bank lends its excess reserves to Amy

Thus,

Third Fidelity Bank    Increase in loans    $ 364500

Part 4

to find total demand deposits created

Demand deposits created = Initial Deposits * 1/Required reserves

Demand deposits created = 500000 * 1/0.10

Demand deposits created = $ 5000000

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