Question

4. 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 10%. The Federal Reserve buys a government bond worth $250,000 from Sean, a customer 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 balance sheet (before the bank makes any new loans).

Assets		Liabilities

Complete the following table to show the effects of the new deposit on excess and required reserves, assuming a required reserve ratio of 10%.

Hint: If the change is negative, be sure to enter the value as a negative number.

Amount Deposited	Change in Excess Reserves	Change in Required Reserves
(Dollars)	(Dollars)	(Dollars)
250,000

Now, suppose First Main Street Bank loans out all of its new excess reserves to Rina, who immediately writes a check for the full amount to Musashi. Musashi then immediately deposits the funds in his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Bob, who writes a check to Yvette, who deposits the money in her account at Third Fidelity Bank. Finally, Third Fidelity lends out all of its new excess reserves to Cho.

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 Checkable Deposits	Increase in Required Reserves	Increase in Loans
	(Dollars)	(Dollars)	(Dollars)
First Main Street Bank
Second Republic Bank
Third Fidelity Bank

Assume this process continues, with each successive loan deposited into a checking account and no banks keeping any excess reserves. Under these assumptions, the $250,000 injection into the money supply results in an overall increase of   in checkable deposits.

Answer 1

The required reserve ratio is 10%. The Federal Reserve buys a government bond worth $250,000

Assets		Liabilities
Reserves	250000	Deposits	250000

Amount Deposited	Change in Excess Reserves	Change in Required Reserves
(Dollars)	(Dollars)	(Dollars)
250,000	250000*0.90 = 225000	250000*0.10 = 25000

	Increase in Checkable Deposits	Increase in Required Reserves	Increase in Loans
	(Dollars)	(Dollars)	(Dollars)
First Main Street Bank	250000	25000	225000
Second Republic Bank	225000	22500	202500
Third Fidelity Bank	202500	20250	180250

Under these assumptions, the $250,000 injection into the money supply results in an overall increase of 250000*1/0.10

=250000*10

=2500000