Question

Tracy Williams deposits $500 that was in her sock drawer in a checking account at his local bank.

a) How does the deposit initially change the T-account of his local bank? How does it change M1? M2?

b) If the bank maintains a reserve ratio of 10%, how will it respond to the new deposit? What will it do?

c)If every time a bank makes a loan they create new money that wasn’t there before, by how much could the total money supply in the economy expand in respond to this initial cash deposit of $500?

d) If the Fed decreases the required reserve ratio to 5%, how do your answers above change?

Answer 1

a)

Assets	Liabilities
Reserve	500	Deposits	500

The amount deposited is a liability to the bank because they have to give it back to Tracy but also an asset since it can be used to make more money.

The amount is deposited in a checkable deposit which comes under M1 so one the one hand cash reduced but checkable deposit increased so M1 and hence M2 remains the same

b) If the bank has a reserve ratio of 10% then it can loan out 90% of the deposit which is $450, the new t account will look like this

Assets	Liabilities
Reserve	50	Deposits	500
Loans	450

c) The total amount the money supply will expand can be calculated by the money multiplier

Money multiplier = 1/reserve ratio

=1/10%

= 10

increase in money supply = 10* 500 = $5000

d) If the reserve ratio is 5%, the money multiplier = 1/5% = 20

Increase in money supply = 20 * 500 = $10,000