Question

Banks in New Transylvania have a desired reserve ratio of 10 percent of deposits and no excess reserves. The currency drain ratio is 50 percent of deposits. Now suppose that the central bank increases the monetary base by \(\$ 1,200\) billion. a. How much do the banks lend in the first round of the money creation process? b. How much of the initial amount lent flows back to the banking system as new deposits? c. How much of the initial amount lent does not return to the banks but is held as currency? d. Why does a second round of lending occur?

Short answer

a. \(1080 billionb. \)540 billionc. $540 billiond. New deposits increase reserves, allowing more lending.

Step-by-step solution

- Determine the Reserve Requirement

Calculate the reserve requirement using the desired reserve ratio. The reserve ratio is 10% of deposits.

- Initial Lending Amount

Calculate how much the banks lend in the first round. Since the reserve ratio is 10%, the banks will lend out 90% of the increase in the monetary base: $$0.9 \times 1200 \text{ billion} = 1080 \text{ billion}$$.

- Calculate Currency Drain

Determine the amount held as currency using the currency drain ratio, which is 50%. Therefore, the amount that does not return to the banks but is held as currency is: $$0.5 \times 1080 \text{ billion} = 540 \text{ billion}$$.

- Calculate Returned Deposits

Calculate the amount that flows back to the banking system as new deposits. Since 50% of the amount lent is held as currency, the remaining 50% returns as deposits: $$0.5 \times 1080 \text{ billion} = 540 \text{ billion}$$.

- Explain the Second Round of Lending

Explain why a second round of lending occurs. The new deposits increase the reserves in the banking system, and banks can then lend out 90% of these new deposits (after holding 10% as required reserves).

Key concepts

Reserve Ratio

The reserve ratio is a fundamental concept in the banking system. It's the fraction of deposits that banks are required to hold as reserves.
In New Transylvania, this ratio is set at 10%.
This means that for every dollar deposited, the bank must keep 10 cents as reserve and can lend out the remaining 90 cents.
The reserve ratio helps ensure that banks have enough funds on hand to meet customers' withdrawal needs.
This ratio also influences the amount of money that banks can create through lending.

Here’s a quick breakdown:

• A high reserve ratio means banks must hold more money and can lend less.

• A low reserve ratio means banks can lend more, increasing the money supply.

So, when calculating the lending capacity of a bank, you first need to determine the reserve requirement based on the reserve ratio. For instance, with a 10% reserve ratio, a bank with \(\text{\$1000}\) in deposits must hold \(\text{\$100}\) and can lend out \(\text{\$900}\).

Currency Drain Ratio

The currency drain ratio represents the portion of money that individuals keep as cash outside of the banking system.
In New Transylvania, the currency drain ratio is 50% of deposits.
This ratio is important because it affects how much of the money lent out by banks actually returns as deposits.

Key points about the currency drain ratio:

• A higher currency drain ratio means people hold more cash, reducing deposits in banks.

• A lower currency drain ratio leads to more funds returning to banks as deposits.

In our scenario, if banks lend \(\text{\$1080}\) billion, 50% (or \(\text{\$540}\) billion) is held as cash by individuals, and the other 50% (\text{\(\$540}\) billion) is deposited back into the banking system.Understanding the currency drain ratio is crucial for predicting the actual flow of money and the effective creation of deposits in the banking system.

Monetary Base

The monetary base refers to the total amount of currency in circulation and reserves held by banks at the central bank.
It is also known as the 'high-powered money' because it is the foundation from which the banking system can create more money through lending.
In our exercise, the central bank increases the monetary base by \(\text{\$1200}\) billion.
This increase allows banks to lend more, which leads to an expansion of the money supply.

Components of the monetary base include:

• Currency in circulation: Cash held by the public.

• Bank reserves: Deposits held by banks at the central bank and vault cash.

By controlling the monetary base, the central bank can influence the amount of money circulating in the economy. If banks have more reserves, they can lend more, and vice versa. This process highlights the importance of the monetary base in regulating economic activity.

Bank Lending

Bank lending is the process through which banks provide loans to individuals and businesses by using their deposits.
In our example, the banks in New Transylvania lend out 90% of the \(\text{\$1200}\) billion increase in the monetary base.
This results in an initial lending of \(\text{\$1080}\) billion.
The lent amount is then used by borrowers for various needs, such as investment or consumption.
Understanding bank lending involves several steps:

1. Calculation of reserves based on the reserve ratio.

2. Determination of the amount lent out (90% in our case).

3. Evaluation of how much returns as deposits and how much is held as currency.

In the first round, \(\text{\$540}\) billion returns as deposits, and \(\text{\$540}\) billion is held as currency.
This process repeats as the new deposits allow further lending, creating a multiplier effect in the money creation process.
Understanding bank lending helps you appreciate how banks contribute to money supply growth and economic activity.