Question

In the extreme case, \(\$ 1,000\) of new reserves put into a bank will ultimately result in an increase of \(\$ 5,000\) of bank deposits, assuming that the reserve ratio is \(20 \%\). But in reality this is rarely the case. What stops the extreme case from being realized?

Short answer

In the extreme case, an increase of \$1,000 in bank reserves results in an increase of \$5,000 in bank deposits, assuming a 20% reserve ratio and a money multiplier of 5. However, this scenario rarely occurs in reality due to various factors such as banks not lending out all excess reserves, fluctuations in the reserve ratio, depositors choosing to hold more cash, and central bank interventions. These factors limit the power of the money multiplier effect in real-world situations, preventing the extreme case from being realized.

Step-by-step solution

Understand the reserve ratio and money multiplier effect

In this case, we are given a reserve ratio of 20%. The reserve ratio is the portion of bank deposits that banks are required to hold as reserves. The money multiplier is calculated as 1 divided by the reserve ratio. In this case, the money multiplier is 1 / (0.20) = 5. The assumption is that every time a bank receives new reserves, they will create new loans based on the reserve ratio and the money multiplier.

Analyze the extreme case scenario

In the extreme case scenario, an increase of \$1,000 in new reserves would lead to an increase of \$5,000 in bank deposits. This is because the bank would create new loans using the money multiplier effect. With a reserve ratio of 20%, the bank can create \$1,000 / 0.20 = \$5,000 in new deposits through the loan creation process.

Identify factors that prevent the extreme case from being realized

Although the money multiplier is a useful economic concept, it rarely occurs to its full potential in reality due to a variety of factors. Some of these factors include: 1. Banks may not lend out all of their excess reserves due to their own risk assessments and profitability considerations. 2. Fluctuations in the reserve ratio. The reserve ratio is not always constant and may be subject to change by the central bank or by economic conditions. 3. Depositors may choose to hold more cash, which will reduce the money multiplier effect. For example, if people withdraw a significant portion of their deposits in cash, it will reduce the level of deposits that the bank can create through the loan creation process. 4. The central bank can intervene in the money market, for example by implementing quantitative easing measures, which can change the dynamics of the money creation process and the reserve ratio. By taking into account these potential factors, it becomes clear that the extreme case scenario of an increase of \$1,000 in bank reserves resulting in an increase of \$5,000 in bank deposits is rarely achieved in reality. There are multiple factors that can limit the power of the money multiplier effect, making it less prominent in real-world scenarios.

Key concepts

Reserve Ratio

Understanding the reserve ratio is essential in comprehending how banks operate. The reserve ratio is the fraction of deposits that a bank must hold in reserves and is set by the central bank. For example, if the reserve ratio is 20%, banks need to keep 20% of their deposits unloaned. If a bank has \(1000 in deposits, it must hold \)200 as reserves, and it can lend out the other $800. Keeping a reserve is a safety measure to ensure banks can meet the demands of deposit withdrawals from customers.

This ratio plays a pivotal role in determining the money multiplier. The money multiplier shows how much new deposit money can be created with each unit of reserves. It is calculated as \( \frac{1}{\text{Reserve Ratio}} \). Therefore, with a 20% reserve ratio, the multiplier is 5, which means every new reserve dollar can create five times the deposit money through the loan creation process.

Bank Deposits

Bank deposits are the funds that customers place in their accounts at a bank. These deposits serve as a foundational element in the banking sector since they are a key source of funds that banks use to extend loans and create additional money supply in the economy. When new reserves are deposited in banks, they don't just sit idle. Instead, they serve as a base for the bank to multiply funds within the economy.

New deposits enhance the bank's lending ability. For each unit of currency in deposits, the bank must hold a percentage as reserve (as dictated by the reserve ratio). The remaining balance can be used for making more loans. Therefore, deposits, by cycle of lending, can greatly amplify the economic impact of an initial deposit, leading to a larger money supply if both individuals and businesses continue to redeposit and spend, although practical constraints often prevent this extreme amplification.

Loan Creation

The loan creation process is at the heart of a bank's operation as it concerns transforming deposits into loans. After keeping the required reserve portion of deposits mandated by the reserve ratio, banks can lend out the remainder. This process not only enables banks to earn interest but also facilitates economic growth by providing readily available funds for investment and consumption.

Through the lending process, banks effectively create new money in the economy. Loan creation works with the multiplication principle. For example, if a bank has an extra $1000 in reserves and a 20% reserve ratio, it can theoretically extend $5000 in new loans. However, the real-world application of loan creation is often limited by factors such as the bank's risk assessment, the need to maintain liquidity, or external economic conditions influencing borrower demand.

Central Bank Intervention

Central bank intervention plays a crucial role in regulating and influencing the money supply within the economy. The central bank uses tools like the reserve ratio adjustment to control how much money banks can lend. By changing the reserve ratio, the central bank can either encourage more lending (by lowering the reserve ratio) or restrain it (by increasing the reserve ratio).

Central banks also engage in practices such as quantitative easing, where they buy securities to increase the money supply, impacting broad economic liquidity and interest rates. This intervention can alter the dynamics of money creation, as banks receive more reserves, allowing more lending without overstretching their reserves. Thus, the effectiveness and limits of money multipliers and related processes are often shaped by central bank policies and interventions, dictating overall economic stability.