Question

So, how do banks “create” money? You’ll probably be surprised to learn that much of the cash in the money supply is somewhat illusory, “created” by the ability of banks to lend their deposits to other borrowers. Read the scenario below to understand how the process functions.

How Does It Work: You’re going to start with $100 worth of cash money. You’ve decided to give that $100 to Ralph as a “gift” and suggest that he deposit it in the bank for a little “cushion”. Now remember, the Federal Reserve requires all banks to hold 7% of all deposits in reserve but allows the bank to lend the remainder.

Jake comes into the bank and requests a loan of $93 to buy a Bluetooth player from Sarah. Sarah decides to deposit the money in the bank.

Al comes to the bank and requests a loan of $86 from the bank to buy a textbook from his friend Joe. Joe decides to deposit the money from the textbook sale in the bank.

Farrah has seen a jacket owned by Trudy that she just has to have, so she goes to the bank and borrow $80 from the bank to buy the jacket. Trudy is pleased that she sold the jacket because she can now pay her phone bill, so she deposits the money in the bank.

1. How much money has each of these depositors put in the bank?

Ralph ______

Sarah ______

Joe     ______

Trudy ______

2. What is the total of deposits made _______
3. How much money was originally deposited in the bank (and available to loan)? ______

So essentially, the banking system multiplied the money in the economy by a factor of 3. Clearly, the growth would increase even further as the economy continues to thrive.

4. Now what would happen if Ralph, Sarah, Joe, and Trudy all wanted to withdraw their money from the banking system at the same time?

The potential for disaster is clear. This is what happened in the early 1930s following the stock market crash of October 1929. In an effort to prevent depositors from withdrawing all their money from a bank at the same time (creating bank failures of the 1930s and the Great Depression), the Federal Government created the Federal Deposit Insurance Corporation [FDIC]. The FDIC offered depositors that their deposits up to a certain amount were guaranteed by the Federal Government should the bank fail. This guarantee was designed to rebuild trust in the US banking system.

Answer 1

Initially, Ralph deposited $100.

Sarah:$93

Joe: $86

Trudy:$80

Initial deposit of $100 has led to creation of 93+86+80= $259 and this process will continue.

Original deposit was $100 and out of which $ 7 was kept aside as Required reserve ratio and $93 was made available for initial loan.

When all; Ralph, Sarah, Joe, and Trudy all want to withdraw their money from the banking system at the same time, it will be bank run as bank will not be able to pay as deposit is less and money is created due to a formula.

1/Reserve ratio.

This many times money will multiply. which is around 14 times. (1/0.07)= 14.28 .