Question

Suppose you deposit $800 into your checking account of bank A. Bank A is a US private bank. The required reserve ratio is 10%.

1. How much does M1 change? How much does M2 change?
2. Draw a figure to illustrate how this initial deposit would increase the money supply for the entire economy. The figure should illustrate at least 3 rounds of deposits.
3. Calculate the maximum amount of new money created for the economy from your deposit.
4. Give two reason to explain why the actual amount of new money created for the economy is less than the amount you calculated in part (c).

Answer 1

a)

The money Multiplier = 1/rr

= 1 /0.10

= 10

Rise in the M1 = 10*800

= 8000

M1 is part of M2, thus change in the M2 would be equal to the change in the M1: 8000

b)

First bank:

Assets	Liabilities
Reserve: 80 Loan : 720	Deposit: 800

Second Bank:

Assets	Liabilities
Reserve: 72 Loan: 648	Deposit: 720

Third Bank:

Assets	Liabilities
Reserve: 64.8 Loan: 583.2	Deposit: 648

c)

Total deposits: 8000

Net Deposits created = 8000 - 800

= 7200

d)

The following could be two reasons:

1) Banks tend to maintain the excess reserve to cushion against the potential crisis

2) Borrowers reduce the borrowing from the bank so banks have more excess reserve.