The money multiplier process
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Explain how do banks create money? What is money multiplier?
American (and world) history is rich with examples of bank crises, often the result of overly expansive loan policies by private banks. As recently as 2007, subprime bank loans (real estate loans made to borrowers with relatively poor credit ratings) have resulted in a significant increase in mortgage defaults. What role, if any, should the Federal Reserve (or other bank regulatory bodies) play in monitoring and remedying these crises?
3- The yield curve reflects interest rates over different maturities for a given debt instrument, like 10-year treasury bonds, or 3-month treasury bills, as well as for private debt. What can you conclude about an upward-sloping yield curve? What if the yield curve becomes inverted (downward-sloping)?
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Solution Summary
The money multiplier process is traced.
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1. The money multiplier process works as follows:
Assume that the required reserve ratio (RRR) is 10%. Suppose the Fed prints $100 and gives it to bank A. Bank A loans out this money to person P1. Person P1 deposits this money in his bank, say bank B. Bank B is required to keep 10% of this deposit as reserve, or $10. Bank B is free to lend out the remaining $90. Suppose they lend out the $90 to person P2. Person P2 takes the money and deposits that in bank C. Bank C now has to keep 10% of $90 as reserves, or $9, and they can lend out $81. This process continues ad-infinitum. Thus at each level the amount of money increases. In the first level it was $100. In the second it became $100 + $90. In the third, $100 + $90 + $81. In the fourth, $100 + $90 + $81 + $72.9, and so on.
The general formula is
Total Money = Initial Deposit + Initial Deposit * (1 - RRR) + Initial ...
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