Question

Assume a simplified banking system in which all banks are subject to a uniform required reserve ratio of 30 percent and checkable deposits are the only form of money. A bank that receives a new deposit of \(\$ 10,000\) is able to extend new loans up to a maximum of a. \(\$ 3,000\) b. \(\$ 7,000\) c. \(\$ 10,000\) d. \(\$ 30,000\)

Short answer

Given the uniform required reserve ratio of 30%, the bank must hold \$3,000 from the new deposit of \$10,000 in reserve (\(10,000 \times 30\% = 3,000\)). The amount that can be loaned out, therefore, is the total deposit minus the required reserve, or \$7,000 (\(10,000 - 3,000 = 7,000\)). Hence,the correct answer is b. \$7,000.

Step-by-step solution

Calculate the required reserve for the new deposit

In order to find out the maximum amount of loans the bank can extend, we first need to determine the required reserve the bank must hold. We can calculate the required reserve by multiplying the deposit amount by the reserve ratio. Required reserve = Deposit amount × Reserve ratio

Determine the maximum amount of new loans

Once we know the required reserve, we can determine the maximum amount of loans the bank can extend. We do this by subtracting the reserve amount from the total deposit amount. Maximum loans = Deposit amount - Required reserve Now, let's calculate the required reserve and the maximum amount of loans.

Apply the formula with given values

Now, let's plug in the given values into the formulas. - Deposit amount: $10,000 - Reserve ratio: 30% Required reserve = \(10,000 × 30\% = \)10,000 × 0.30 = \$3,000$ Now, let's calculate the maximum loans. Maximum loans = \(10,000 - \)3,000 = \$7,000$

Choose the correct answer

Based on our calculations, the maximum amount of new loans the bank can extend is $7,000. So the correct answer is, b. \(7,000\)

Key concepts

Required Reserve Ratio

The Required Reserve Ratio (RRR) is a critical regulatory guideline for banks, which dictates the minimum fraction of customer deposits that each bank must keep at hand, rather than lending out or investing. This reserve ratio acts as a safeguard to ensure that banks have enough funds available to manage daily transactions and to provide a buffer to default on loans.

In the given exercise, with a RRR of 30%, this means that for every dollar deposited, the bank must keep 30 cents in reserve. This reserve is not actively used for lending or investment purposes but is held either in the bank vault or at a central bank. By controlling the RRR, monetary authorities can influence the lending capacity of banks, thus affecting the overall money supply in the economy.

Checkable Deposits

Checkable deposits refer to money placed in checking accounts from which depositors can write checks and use debit cards to access funds. They are regarded as money since they can be readily converted to cash and used to facilitate transactions. Checkable deposits also form a significant component of the money supply measured in the economy.

In our exercise scenario, these checkable deposits are the only form of money in that simplified banking system, and so, the entire money supply consists of what individuals and businesses deposit in the banks. These deposits represent the base on which banks can build upon through extending loans, subject to adherence to the required reserve ratio. The facility of using checkable deposits as a form of money underscores their importance in daily financial transactions and economic stability.

Maximum Loan Calculation

The maximum loan calculation is a straightforward but powerful concept to understand banking and money creation. It helps us to determine the actual amount a bank can lend out from the deposited funds after maintaining the required reserves.

To calculate the maximum loan, you simply subtract the required reserve from the total deposit. This equation embodies the principle that a part of the deposit is tucked away to comply with reserve requirements, and only the remaining funds are available for the bank to lend.

Following the Exercise

In our example, with a deposit of \(10,000 and the Required Reserve Ratio set to 30%, the calculation would be: Maximum loans = Total Deposits - Required Reserves. Given that the required reserve is \)3,000 (30% of \(10,000), the bank is left with \)7,000 to lend. This limitation ensures banks have a cushion against a sudden withdrawal demand and illustrates the leveraged nature of the banking system where money is recycled and multiplied through the lending process.

Monetary Policy

Monetary policy refers to the actions undertaken by a central bank, such as the Federal Reserve in the United States, to control the money supply and achieve macroeconomic goals like controlling inflation, managing employment levels, and maintaining financial system stability.

One of the critical instruments of monetary policy is the manipulation of the required reserve ratio. By increasing the ratio, central banks can reduce the amount banks have available for lending, contracting the money supply, which often has a cooling effect on the economy. Conversely, lowering the ratio allows banks to lend more, thus expanding the money supply and stimulating economic activity.

The reserve ratio, alongside other instruments such as interest rates and open market operations, enables central banks to influence lending, spending, and inflation, showcasing the significance of monetary policy in guiding economic trends and ensuring a stable economic environment.