Question

Suppose you deposit \(\$ 2,000\) in currency into your checking account at a branch of Bank of America, which we will assume has no excess reserves at the time you make your deposit. Also assume that the required reserve ratio is 0.20 , or 20 percent. a. Use a T-account to show the initial effect of this transaction on Bank of America's balance sheet. b. Suppose that Bank of America makes the maximum loan it can from the funds you deposited. Using a T-account, show the initial effect of granting the loan on Bank of America's balance sheet. Also include on this T-account the transaction from part (a). c. Now suppose that whoever took out the loan in part (b) writes a check for this amount and that the person receiving the check deposits it in a branch of Citibank. Show the effect of these transactions on the balance sheets of Bank of America and Citibank after the check has been cleared. (On the T-account for Bank of America, include the transactions from parts (a) and (b).) d. What is the maximum increase in checking account deposits that can result from your \(\$ 2,000\) deposit? What is the maximum increase in the money supply? Briefly explain.

Short answer

The maximum potential increase in both the checking account deposits and the money supply resulting from an initial deposit of \$2000 is \$10000.

Step-by-step solution

Initial Deposit

First, calculate the initial effect of the deposit on Bank of America's balance sheet.The initial $2000 deposit increases both its assets (reserves) and liabilities (checking account deposits). The T-account is:\[\begin{{array}}{{ll}}\text{{Assets (reserves)}} & \text{{Liabilities (deposits)}} \+ \$2000 & + \$2000 \\end{{array}}\]

Maximum Loan

Next, we calculate the maximum loan the bank can give out from the deposit according to the reserve requirement (20%).The bank can loan out the amount of the deposit minus the required reserves. The reserves are 20% of \$2000, i.e. \$400, hence the bank can loan \$1600. The T-account now, including the deposit and the loan, is:\[\begin{{array}}{{ll}}\text{{Assets (reserves + loans)}} & \text{{Liabilities (deposits)}} \+ \$2000 (\$400 + \$1600) & + \$2000 \\end{{array}}\]

Check Deposit in Citibank

Assuming the borrower writes a check for the loan amount and it's deposited into Citibank, show the effect of this transaction.Transaction reduces Bank of America's reserves by the loan amount, and increases Citibank's. Bank of America's T-account becomes:\[\begin{{array}}{{ll}}\text{{Assets (reserves + loans)}} & \text{{Liabilities (deposits)}} \\$400 - \$1600 & \$2000 \\end{{array}}\]Citibank's T-account becomes:\[\begin{{array}}{{ll}}\text{{Assets (reserves)}} & \text{{Liabilities (deposits)}} \+ \$1600 & + \$1600 \\end{{array}}\]

Maximum Increase in Checking Accounts and Money Supply

Find the total increase in checking account deposits.According to the money multiplier theory (where multiplier = 1/reserve requirement), the maximum increase in checking deposits is deposit * multiplier. The multiplier is 1/0.2 = 5, hence maximum increase in deposits is \$2000 * 5 = \$10000.For the maximum increase in money supply, since all the newly created deposits are also part of the money supply, the increase is also \$10000.

Key concepts

Required Reserve Ratio

The required reserve ratio is a crucial component of the banking system. It determines how much money a bank must keep on hand and not loan out. When you hear 'required reserve ratio,' think of it as the safekeeping amount—a portion of deposits that banks cannot touch.

For example, if the ratio is 20%, as in our case, banks must hold 20% of all deposits as reserves. This means if someone deposits $2000, the bank must keep $400 (which is 20% of $2000) in reserve.

This concept ensures banks have a precautionary buffer to handle unexpected withdrawals, nurturing trust in the banking system. Because of this reserve rule, only $1600 of a $2000 deposit becomes available for loans. This rule significantly impacts the money creation process in the economy.

T-account

A T-account is a simple and useful tool to visualize transactions and their impacts on a bank’s balance sheet. Think of it as a ledger with two sides: assets on one side and liabilities on the other.

In the example, when you deposit $2000 into your account, the T-account shows an increase in the bank’s assets (reserves) by $2000 and simultaneously increases liabilities (deposits) by the same amount.

After the bank loans out $1600 of your deposit, the T-account adjusts again. Now, it shows assets as $400 in reserves and $1600 in loans, still balancing against the $2000 in liabilities.

This simplistic format helps visualize the dual impact of transactions, ensuring that banks can track their money accurately. With the T-account, every transaction can be pursued systematically, reinforcing the integrity of financial operations.

Money Multiplier

The money multiplier is a fascinating concept. It reveals how banks can amplify deposits into a larger sum of money circulating within the economy.

Here’s how it works: By maintaining a certain reserve ratio, the bank can loan out the remaining deposit fraction, which other banks can re-deposit and re-loan. The money multiplier is calculated as the reciprocal of the reserve ratio.

• For a reserve ratio of 0.2 (20%), the money multiplier is 1/0.2 = 5.

This means every initial deposit could potentially expand the money supply up to five times its original amount.

In our case, the $2000 deposit could increase the total money supply to $10,000, illustrating the multiplying effect banks have on the economy through repeated lending.

Bank Balance Sheets

Bank balance sheets are like windows into the banking world, showing what a bank owns (assets) and owes (liabilities). It includes components like reserves, loans, and deposits, maintaining a balance.

In our scenario, when you deposit $2000 into Bank of America, it initially increases both assets (reserves) and liabilities (deposits) by $2000.

Once Bank of America loans out $1600, this amount shifts from being just reserves to existing as loans on the assets side while reserves stand at $400.

Later transactions also affect balance sheets of other banks like Citibank, where receiving a check deposit increases both its assets and liabilities by the check amount.

Understanding this flow helps visualize the ripple effects of each monetary transaction, emphasizing the dynamic role banks play in managing money within the economy.