Question

Suppose that in the banking system as a whole demand deposits are equal to \(\$ 80,000,000\) and reserves are equal to \(\$ 17,000,000\) with a legal reserve ratio of \(10 \%\). If the Federal Reserve doubles the required ratio, by how much will the money-creating potential of the banking system as a whole drop?

Short answer

The money-creating potential of the banking system as a whole will drop by \(\$400,000,000\) when the Federal Reserve doubles the required reserve ratio from \(10\%\) to \(20\%\).

Step-by-step solution

Calculate the original money-creating potential

Using the given demand deposits and the original reserve ratio, we can calculate the money-creating potential of the banking system. Original money-creating potential = Demand deposits * (1 / Reserve requirement ratio) = \(80,000,000 * (1 / 0.1)\)

Calculation

Now, do the calculation: Original money-creating potential = \(80,000,000 * (1 / 0.1) = 800,000,000\)

Calculate the new money-creating potential

We know that the Federal Reserve doubled the required reserve ratio, meaning the new reserve requirement is \(2 * 10\% = 20\%\). Now we have to calculate the new money-creating potential in the banking system. New money-creating potential = Demand deposits * (1 / New reserve requirement ratio) = \(80,000,000 * (1 / 0.2)\)

Calculation

Now, do the calculation: New money-creating potential = \(80,000,000 * (1 / 0.2) = 400,000,000\)

Find the difference in money-creating potential

To find how much the money-creating potential dropped, we need to subtract the new money-creating potential from the original one. Drop in money-creating potential = Original money-creating potential - New money-creating potential = \(800,000,000 - 400,000,000\)

Final answer

Now, do the subtraction: Drop in money-creating potential = \(800,000,000 - 400,000,000 = 400,000,000\) So, the money-creating potential of the banking system as a whole will drop by \(\$400,000,000\).

Key concepts

Reserve Requirement Ratio

The reserve requirement ratio is a critical regulation set by central banking authorities, such as the Federal Reserve System in the United States. It represents the percentage of depositors' balances that banks must have on hand as cash. This ratio is not to be used for lending or investment purposes. For instance, if the reserve ratio is 10%, for every dollar held in a demand deposit, a bank must hold 10 cents in reserve.

The ability of banks to create money is closely tied to this ratio. When the ratio is low, banks can lend more of their deposits, which increases the money supply through a process called fractional-reserve banking. Conversely, when the ratio is increased, banks must hold more funds in reserve, reducing the amount they can lend, which in turn decreases the money-creating potential of the banking system. Understanding this concept is essential to analyze the impact of regulatory changes on the banking system and the economy.

Federal Reserve System

The Federal Reserve System, often referred to as 'the Fed', is the central bank of the United States. It plays a pivotal role in the country's monetary policy and banking system. One of its main responsibilities is to manage the reserve requirement ratio for member banks. By adjusting this ratio, the Fed controls the amount of money that banks can create.

The Federal Reserve uses various tools to carry out its monetary policies, including the manipulation of interest rates and reserve requirements for banks. These actions can influence the availability and cost of money and credit, which in turn affects economic growth. For instance, a decision to double the reserve requirement ratio, as mentioned in our exercise, would have a significant contractionary effect on the money supply.

Demand Deposits

Demand deposits are the funds that customers deposit into accounts like checking accounts and that they can withdraw at any time without any prior notice to the bank. These are a cornerstone of the money supply because they are used to make payments and are considered money in their most liquid form.

In the context of the money-creating potential of a banking system, demand deposits serve as the base for banks to create additional money through loans. When a person deposits money into a checking account, the bank can then lend out a portion of this deposit, which will get deposited again, forming an ongoing cycle of depositing and lending, often referred to as the money multiplier effect. The amount of money that can be created from a single dollar of demand deposits is inversely related to the reserve requirement ratio. Lower reserve ratios lead to a higher money multiplier, indicating a greater capacity for banks to expand the money supply through their lending activities.