Question 7 Chapter 16 The money creation process
Explanation: Close Explanation
When Larry deposits the $1,500,000 into First Main Street Bank, it create
... [Show More] s both an asset and a liability
for the bank.
On the asset side of the T-account, the $1,500,000 increases the bank's reserves. The bank can use
some of this additional reserve to make loans to other people.
On the liability side of the T-account, the $1,500,000 is recorded as a demand deposit, because Larry
could demand his deposit back at any time by coming into the bank and asking for it, writing a check, or
using a debit card.
Assets Liabilities
Reserves $1,500,000 Deposits $1,500,000
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 Larry,
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).
Assets Liabilities
Points: 0.75 / 1
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.
1,500,000 1,200,000 300,000
Explanation: Close Explanation
Because the required reserve ratio is 20%, First Main Street Bank is required to hold 20% of its fresh
reserves (that is, the initial deposit). Since 20% of $1,500,000 is $300,000, this means that First Main
Street Bank's required reserve has increased by$300,000.
The remaining 80% of the fresh reserves, or $1,200,000, is excess reserve and can be used to make
loans.
Amount Deposited Change in Excess Reserves Change in Required Reserves
(Dollars) (Dollars) (Dollars)
Points: 1 / 1
Now, suppose First Main Street Bank loans out all of its new excess reserves to Janet, who immediately uses
the funds to write a check to Felix. Felix 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 Larry, who writes a check
to Megan, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new
excess reserves to Susan 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.
Increase in
Deposits
Increase in Required
Reserves Increase in Loans
(Dollars) (Dollars) (Dollars)
First Main Street 1,500,000 300,000 1,200,000
Bank
Second Republic
Bank
Third Fidelity Bank
Explanation:
Points: 1 / 1
Close Explanation
You already found that of the $1,500,000 initial deposit, 20% (or $300,000) had to be held as required
reserves and the remaining 80% (or $1,200,000) could be loaned out.
192,000 768,000
1,200,000 240,000 960,000
960,000
$7,500,000
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.
Points: 1 / 1
Explanation: Close Explanation
Under the assumptions stated in the problem, you can use the money multiplier to calculate the eventual
effect of the $1,500,000 injection into the money supply.
The formula for the money multiplier is , where is the required reserve ratio. Therefore, the resulting
change in demand deposits is as follows:
If you follow that $1,200,000 loan, you can see that when it is deposited into Second Republic Bank,
20% of that $1,200,000 must be held as required reserves by Second Republic Bank and the remaining
80% can be loaned out:
Now, those $960,000 of excess reserves can be loaned out. When they are loaned and then deposited
into Third Fidelity Bank, Third Fidelity Bank's required and excess reserves increase in the same way: [Show Less]