Question

assume that no banks hold excess reserves, and the public holds no currency. If a bank sells a $500 security to the Fed, explain what happens to this bank and two additional steps in the deposit expansion process, assuming a 20% reserve requirement. How much do deposits and loans increase for the banking system when the process is completed?

Answer 1

Bank A will receive $500 in reserves from the sale which will be recorded as excess reserves and so the bank will loan all of $500 which will be then deposited into Bank B increasing it's reserves.

Bank B will keep 20% as reserves and will have $400 as excess reserves which it can lend which will be then deposited into Bank C increasing it's reserves.

Bank C will keep 20% as reserves and the bank will have $320 as excess reserves which it can lend and the process continues until there are no excess reserves in the system.

Given a reserve requirement this will increase loans and deposits by 1/Rx500 = 1/.20x500 = 5x500 = $2500.