Question

Suppose that the banking system in Canada has a required reserve ratio of 10 percent while the banking system in the United States has a required reserve ratio of 20 percent. In which country would \(\$ 100\) of initial excess reserves be able to cause a larger total amount of money creation? a. Canada. b. United States.

Short answer

a. Canada.

Step-by-step solution

Understanding the Reserve Ratio

The reserve ratio is the percentage of deposits that banks are required to keep on hand and not loan out. A lower reserve ratio allows banks to lend more money from their deposits.

Calculating the Money Multiplier

The money multiplier is the reciprocal of the reserve ratio. For Canada, with a reserve ratio of 10%, the money multiplier is \( \frac{1}{0.10} = 10 \). For the USA, with a reserve ratio of 20%, the money multiplier is \( \frac{1}{0.20} = 5 \).

Determining Money Creation Potential

The total money creation potential is calculated by multiplying the excess reserves by the money multiplier. In Canada, the potential increase in money supply would be \( 100 \times 10 = 1000 \). In the USA, it would be \( 100 \times 5 = 500 \).

Comparing Results

Comparing the results, Canada has a larger total money creation potential of 1000, compared to the USA's 500. This means Canada's banking system can create more money with the initial \( \$100 \) of excess reserves.

Key concepts

Banking System

The banking system is a network of financial institutions that provide services to manage money, such as accepting deposits and giving loans. Two major types of banking systems exist in different countries: centralized and decentralized systems. In a centralized system, a central bank governs all operations, while a decentralized system involves various independent banks working with some regulatory oversight. Banks in a country are crucial for economic stability, as they control the flow of money and credit. They stimulate economic activity by making loans, creating opportunities for businesses and individuals. The effectiveness of a banking system is measured by its ability to manage monetary supply, balance risks, and support financial transactions. A significant aspect of this management involves maintaining appropriate reserve ratios, which helps determine how much money banks can lend out versus how much they must keep on hand.

Reserve Ratio

The reserve ratio is a critical component of banking operations. It indicates the percentage of deposits a bank must hold as reserves, not to be loaned out. These reserves can be held as cash in the bank vault or as deposits with a central bank. The reserve ratio varies between nations, influencing how much money banks can create from their deposits. A lower reserve ratio means banks have more capacity to loan out money, fostering greater economic growth. To illustrate:

• If the reserve ratio is 10%, for every $100 deposited, a bank must keep $10 and can lend out $90.
• In contrast, with a 20% reserve ratio, the bank holds $20 per $100 deposit, lending out $80 instead.

The reserve ratio is a tool used by central banks to influence the economy, controlling inflation and stabilizing the currency by regulating how much money enters circulation.

Money Multiplier

The money multiplier effect highlights how banks create money through the lending process. It reveals how initial deposits lead to a more significant increase in the total money supply. The calculation comes from taking the reciprocal of the reserve ratio. Thus, the money multiplier formula is:\[\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}\]For instance:

• In Canada, with a reserve ratio of 10%, the multiplier is \( \frac{1}{0.10} = 10 \).
• In the United States, a ratio of 20% yields a multiplier of \( \frac{1}{0.20} = 5 \).

This means that in Canada, every dollar in reserve can potentially create 10 dollars in the broader economy, compared to 5 dollars in the United States. The money multiplier shows the potential for money creation and illustrates why different reserve requirements affect economic growth.

Excess Reserves

Excess reserves refer to the funds that banks hold over the minimum required reserves. Banks have the flexibility to decide whether to hold excess reserves or lend them out. The potential for money creation lies in these excess reserves, as they represent the portion of money that can be multiplied through the banking system’s process of lending.For context:

• If a bank has \(100 in excess reserves in a system with a 10% reserve ratio, this amount can lead to a total money creation of \( 100 \times 10 = 1000 \).
• In a system with a 20% reserve ratio, the same \)100 results in \( 100 \times 5 = 500 \) creation.

Choosing to hold onto or to lend these excess reserves affects both the bank's profitability and the overall money supply. If economic conditions are favorable, lending excess reserves can support growth. However, during economic uncertainty, banks might prefer to hold onto these reserves, affecting the speed of money circulation in the economy.