Question

First Bank has total deposits of \(\$ 2,000,000\) and legal reserves of \(\$ 220,000\). a. If the reserve requirement is 10 percent, what is the maximum loan that First Bank can make, and what is the maximum increase in the money supply based on First Bank's reserve position? b. If the reserve requirement is changed to 5 percent, how much can First Bank lend, and by how much can the money supply be expanded?

Short answer

Answer: a. With a 10 percent reserve requirement, the maximum loan First Bank can make is $20,000, and the maximum increase in the money supply is also $20,000. b. With a 5 percent reserve requirement, the maximum loan First Bank can make is $120,000, and the maximum increase in the money supply is also $120,000.

Step-by-step solution

To find the required reserve for a 10 percent reserve requirement, multiply the total deposits by the reserve requirement: Required reserve = Total deposits * Reserve requirement Required reserve = $2,000,000 * 10\%= \$200,000 ##Step 2: Calculate the excess reserve for 10 percent reserve requirement##

Subtract the required reserve from the legal reserves to find the excess reserve: Excess reserve = Legal reserves - Required reserve Excess reserve = \(220,000 - \)200,000 = \$20,000 ##Step 3: Find the maximum loan and money supply increase for 10 percent reserve requirement##

The maximum loan that the bank can make is equal to the excess reserve, which is \(20,000. The maximum increase in the money supply is also equal to the excess reserve, which is \)20,000. ##Step 4: Calculate required reserve for 5 percent reserve requirement##

Repeat the process in Step 1, but this time using the 5 percent reserve requirement: Required reserve = Total deposits * Reserve requirement Required reserve = $2,000,000 * 5\%= \$100,000 ##Step 5: Calculate the excess reserve for 5 percent reserve requirement##

Subtract the required reserve from the legal reserves to find the excess reserve: Excess reserve = Legal reserves - Required reserve Excess reserve = \(220,000 - \)100,000 = \$120,000 ##Step 6: Find the maximum loan and money supply increase for 5 percent reserve requirement##

The maximum loan that the bank can make is equal to the excess reserve, which is \(120,000. The maximum increase in the money supply is also equal to the excess reserve, which is \)120,000. Answers: a. With a 10 percent reserve requirement, the maximum loan that First Bank can make is \(20,000, and the maximum increase in the money supply is also \)20,000. b. With a 5 percent reserve requirement, the maximum loan that First Bank can make is \(120,000, and the maximum increase in the money supply is also \)120,000.