Question

Suppose that Mariel deposits \(\$ 100\) in her local bank. If the Fed's reserve requirement is 15 percent, how much can the bank loan out on the basis of Mariel's deposit? What concept does this scenario illustrate?

Short answer

The bank can loan out $85; this illustrates fractional-reserve banking.

Step-by-step solution

Understand the Reserve Requirement

The reserve requirement is the portion of depositors' balances that banks must have on hand as cash. In this case, the reserve requirement is 15%. This means that the bank must keep 15% of Mariel's deposit in reserve and cannot loan this amount out.

Calculate the Reserve Amount

To find the amount the bank must keep in reserve, calculate 15% of Mariel's deposit:\[\text{Reserve Amount} = 0.15 \times 100 = 15\] The bank must keep $15 in reserve from Mariel’s deposit.

Calculate the Loanable Amount

The bank can loan out the remaining balance of Mariel's deposit after setting aside the required reserve. Subtract the reserve amount from the total deposit:\[\text{Loanable Amount} = 100 - 15 = 85\]The bank can loan out $85 of Mariel's deposit.

Identify the Concept Illustrated

This scenario illustrates the concept of "fractional-reserve banking." In fractional-reserve banking, banks hold a fraction of their deposits in reserve and are able to lend out the rest, thereby creating credit and increasing the money supply in the economy.

Key concepts

Reserve Requirement

The concept of a reserve requirement is fundamental to understanding how banks operate within a fractional-reserve banking system. In simple terms, the reserve requirement is the specific percentage of customer deposits that a bank must keep on hand as a reserve. This amount cannot be loaned out or used for other purposes, serving as a safety measure to ensure the bank has enough liquidity to meet withdrawal demands.
For example, if Mariel deposits \(100 in her bank and the reserve requirement set by the central bank (like the Federal Reserve in the United States) is 15%, the bank must keep \)15 as reserves. To calculate this, you multiply the deposit amount by the reserve percentage: \[ 0.15 \times 100 = 15 \] The remainder of the deposit, which in this case is $85, is available for the bank to use in other ways, such as lending to other customers.
The reserve requirement acts as a tool for central banks to influence the amount of money circulating in the economy, supporting financial stability and controlling inflation.

Money Supply

Money supply refers to the total amount of money available in an economy at a particular time. It encompasses cash, coins, and balances held in bank accounts, easily accessible for spending by consumers and firms. Changes in the money supply have significant implications for an economy, influencing inflation, employment, and economic growth.
Fractional-reserve banking directly affects the money supply. When banks receive deposits, they don't need to keep 100% of those deposits on reserve. Instead, under the fractional-reserve system, they only retain a portion (as mandated by the reserve requirement) and can loan out the rest. This process increases the money supply because the money deposited can be "recycled" into new loans, creating more deposits. For instance, when Mariel's bank lends $85 to another person, and that person deposits it back into the banking system, this loan becomes part of the money supply again.
The more money banks lend out, the more the money supply expands, enabling economic growth, but it also requires careful regulation to prevent inflation and economic instability.

Credit Creation

Credit creation is a process inherent to fractional-reserve banking whereby banks expand the amount of credit available in the economy through the practice of lending. When banks receive deposits, they are able to lend out a significant portion of these funds while maintaining a fraction as reserves. This practice enables banks to "create" money through the issuance of loans.
Consider Mariel's deposit of $100. The bank, keeping $15 as reserves, can lend $85 to another customer. This loan becomes a deposit in another bank account, leading to further lending opportunities by that bank. As more banks continue this cycle of accepting deposits and making loans, the initial deposit initiates a multiplier effect, thereby expanding credit availability.
Credit creation is powerful as it facilitates increased investment and consumption. New business ventures rely heavily on banks' ability to provide credit, which fuels job creation and economic development. However, unchecked credit creation can lead to asset bubbles and financial crises, highlighting the need for prudent regulatory oversight.