Question

Suppose there are $1000 of reserves in the banking system. Assume that banks are required to hold 5% of their deposits as required reserves. Assume further, that banks wish to hold zero excess reserves.

a. What is the total amount of deposits in the banking system?

b. If banks decided to hold reserves in excess of those required what would happen to the money multiplier and the money supply? Why?

c. If households decided not to deposit all their money in the bank but to keep some of it in the form of cash outside of the banking system,

Answer 1

a)Total Amount of Deposits=( 1/5%)× 1000

Total amount of Deposits= $20000.

b) if Banks decided to hold reserves in excess of those required then the credit creation capacity of the commercial banks reduces because they do not loan out to their maximum capacity and keeps fund idle as excess Reserves. Hence, credit creation and money supply Decrease. Also as a result of keeping excess Reserves the money multiplier also decreases. So, if Banks decided to hold reserves in excess of those required then the money multiplier and money supply both decrease.

c) if households decided not to deposit all their money in the bank but to keep some of it in the form of cash outside of the banking system then the total deposits of the banks would decrease. As a result, the banks' Supply of loans would Decrease and since, there is now less loans given by banks, money supply also Decreases.