Question

Fred creates \(\$ 2,000\) in currency with the snap of his fingers and deposits it in bank A. The reserve requirement is 10 percent By how much does the money supply increase?

Short answer

The total increase in the money supply will be $20,000.

Step-by-step solution

Calculate Reserved Amount

First, determine the amount the bank needs to keep in reserves based on the reserve requirement. It can be calculated by multiplying the deposit amount with the reserve requirement. So, for the deposit of $2000 with a reserve requirement of 10%, the reserve will be $2000 * 0.10 = $200.

Find Money Available for Lending

Next, calculate the amount available for lending by subtracting the reserved amount from the total deposit. That is $2000 - $200 = $1800.

Calculate Total Money Supply Increase

Finally, calculate the potential increase in the money supply, recognizing that the deposit can be lent out, redeposited, and re-lent, each time with a reserve requirement of 10%. This is calculated by dividing the original deposit by the reserve requirement. Therefore, the total increase in the money supply is $2000 / 0.10 = $20,000. This is because each time money is deposited, 90% of it can be loaned out and potentially become a new deposit in the banking system.

Key concepts

Reserve Requirement

The reserve requirement is a regulation put in place by central banks to ensure that commercial banks maintain a certain percentage of their deposit liabilities as reserves. Reserves are crucial because they help banks manage withdrawals and lend money responsibly. In our exercise, the reserve requirement is set to 10%, meaning for every deposit, 10% must be kept and cannot be used for lending purposes.

This percentage acts as a safeguard for financial stability. By having a reserve, banks are prepared for situations where depositors might want to withdraw their money. A reserve requirement:

• Ensures liquidity in the banking system.
• Acts as a control measure for money circulation.
• Prevents bank runs by making sure a portion of deposits are always available.

For the exercise example, with a deposit of $2000, the bank must hold $200 as reserves, calculated as $2000 multiplied by 10% (or 0.10).

Bank Lending

Once a bank determines the amount needed to keep in reserves, the remaining deposit is available for lending. This is how banks generate profits and facilitate economic growth. In our example, after holding $200 in reserves from the $2000 deposit, bank A has $1800 available for lending. These funds can then be issued as loans to borrowers for various purposes ranging from home loans to business investments.

Lending by banks plays a key role in the economy:

• It helps in creating new economic opportunities as enterprises and individuals can finance activities they might not afford outright.
• Plays a part in determining the overall money supply via the lending process.
• Influences interest rates in the economy, as the availability of credit can impact the cost of borrowing.

Thus, the function of bank lending is fundamental in the cycle of money creation and distribution. Each time the $1800 is loaned, it enters the economy, potentially creating new deposits and further increasing the money supply.

Deposit Multiplier

The deposit multiplier is a concept that helps us understand the potential extent to which the initial deposit can increase the money supply. It all hinges on the reserve requirement ratio. In simpler terms, when a bank receives a deposit, it keeps a part of it in reserve and lends the rest. This lent-out money can become deposits in other banks, where the same lending process repeats.

• The deposit multiplier formula is: 1 / Reserve Requirement Ratio.
• In our given example with a 10% reserve requirement, the multiplier is 1 / 0.10 = 10.

Applying this multiplier means the initial $2000 deposit potentially raises the total money supply by up to $20,000. This occurs through the repetitive cycle of lending and depositing in the banking system. Each cycle circulates more money around the economy, demonstrating how banks can amplify the amount of money in circulation beyond the initial deposit amount through their lending activities.