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Reserve requirements

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4. Suppose Bank A, which faces a reserve requirement of 10 percent, receives a \$1,000 deposit from a customer. Assuming that it wishes to hold no excess reserves, determine how much the bank should lend. Show your answer on Bank A's balance sheet.

Assuming that the loan shown in Bank A's balance sheet is re-deposited in Bank B, show the changes in Bank B's balance sheet if it lends out the maximum possible.

Repeat this process for three additional banks: C, D, and E.

Using the simple money multiplier, calculate the total change in the money supply resulting from the \$1,000 initial deposit (but do not include the initial \$1,000 investment as part of the change).

Assume Banks A, B, C, D, and E each wish to hold 5 percent excess reserves. How would holding this level of excess reserves affect the total change in the money supply (again, excluding the initial \$1,000 investment as part of the change)?

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Solution Preview

Money multiplier represents the ability of a fractional-reserve banking system to create money within the economy, that is, for each dollar of reserves; the money supply is some multiple of that value.

The Money Multiplier

The money multiplier tells us the maximum amount of new demand-deposit money that can be created by a single initial dollar of excess reserves. This multiplier, m, is the inverse of the reserve requirement, R: m = 1/R. This note will demonstrate that fact.

Suppose some initial amount, d1, is deposited into the banking system. With a reserve requirement of R, this deposit creates initial excess reserves equal to E1 = (1 - R) x d1. Assuming all of this amount is lent out and redeposited within the system, these excess reserves become new money: D M1 = E1 = (1 - R) x d1. This second deposit creates its own excess reserves equal to E2 = (1 - R) x D M1 ...

Solution Summary

This explains the concept of Reserve requirements

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