Question

The Fed purchases $100,000 worth of bonds from First National Bank. Suppose that the required reserve ratio is 20 percent. Answer the following questions. Note: You must show all your work for full credit. Briefly explain your answers as well.

-What is the maximum amount that First National Bank by itself can lend out?

-What is the maximum amount that the banking system as a whole can lend out?

-In the real world, why would the total amount of loans made by the banking system as a whole beless than the maximum amount you found in Part (b) above?

Answer 1

The first National Bank receives $100,000 so it will keep 20% of this amount as required reserves which becomes a $20,000. Therefore the maximum amount that the National Bank can lend itself is $80,000. The value of the money multiplier is given by 1 / 20% which is 5. Therefore the maximum amount that the banking system can lend out is 5 x 80000 which gives the $400,000.

In Real world total amount of loans made by the banking system is always less than the maximum amount. This happens because they are always excess reserves in the banking system which are never lent out.