Question

Suppose that the Fed has set the reserve ratio at 10 percent and that banks collectively have \(\$ 2\) billion in excess reserves. What is the maximum amount of new checkable-deposit money that can be created by the banking system? a. \(\$ 0\) b. \(\$ 200\) million. c. \(\$ 2\) billion. d. \(\$ 20\) billion.

Short answer

The maximum amount of new checkable-deposit money is \$20 billion (option d).

Step-by-step solution

Understanding the Reserve Ratio

The reserve ratio is the fraction of depositors' balances that banks must have on hand as reserves, which is 10% in this scenario. This means for every dollar deposited, the bank must keep 10 cents in reserves and can loan out the remaining 90 cents.

Excess Reserves Definition

Excess reserves refer to bank reserves over and above the reserve requirement set by the Fed. Here, banks have $2 billion in excess reserves, meaning this amount is not required to be kept as reserves and can be used to create new money through lending.

Calculating Money Multiplier

The money multiplier is the factor by which banks can expand the money supply. It is calculated as the reciprocal of the reserve ratio. Given a reserve ratio of 10%, the money multiplier is:\[\text{Money Multiplier} = \frac{1}{0.10} = 10\]

Calculating Maximum New Checkable-Deposit Money

Using the money multiplier, we find the maximum amount of new checkable-deposit money that can be created by multiplying the excess reserves by the money multiplier:\[\text{Maximum New Money} = \text{Excess Reserves} \times \text{Money Multiplier} = \\(2 \text{ billion} \times 10 = \\)20 \text{ billion}\]

Answer Selection

The maximum amount of new checkable-deposit money that can be created is \(20 billion according to our calculation. Thus, option d (\\)20 billion) is the correct answer.

Key concepts

Reserve Ratio

The reserve ratio is an essential concept in understanding how banks manage deposits and reserves. It represents the percentage of deposits that banks are required by regulation to hold in reserve, either in their vaults or at the central bank. This ensures that banks can meet their customers' withdrawal demands while also playing a crucial role in controlling the money supply within the economy.

The Federal Reserve sets the reserve ratio, and in this scenario, it is set at 10%. This means for every dollar a bank receives in deposits, it must keep 10 cents as reserves and is allowed to loan out the remaining 90 cents. By regulating how much money banks can lend, the reserve ratio helps stabilize the economy and control inflation.

Excess Reserves

Excess reserves are bank reserves that exceed the requirements set by the reserve ratio. They represent the additional funds that banks have available to lend to customers, beyond what they are required to hold as reserves. When banks have excess reserves, they are in a position to extend more loans and thus create more money in the economy by leveraging these reserves.

In our example, banks collectively have $2 billion in excess reserves. These funds are not subject to the reserve requirement and can be used to increase the money supply. Excess reserves are crucial for understanding how banks can stimulate economic activity through lending. The more excess reserves banks hold, the greater their capacity to extend credit and foster economic growth.

Money Multiplier

The money multiplier is a concept that illustrates how a single unit of currency in reserves can lead to a more significant increase in the total money supply through banking activities. The multiplier is calculated as the reciprocal of the reserve ratio. For instance, if the reserve ratio is 10%, the money multiplier would be calculated as:

• \[ \text{Money Multiplier} = \frac{1}{0.10} = 10 \]

This means that for every dollar held in reserves, banks can potentially create $10 in new money by issuing loans.

The money multiplier is a central aspect of modern banking, as it demonstrates the ability of the banking system to multiply the effects of deposits via the lending process. By using excess reserves with the money multiplier, banks create a magnified impact on the economy.

Banking System

The banking system plays a vital role in money creation and economic stability. It consists of the network of banks and financial institutions that handle the deposit and loan activities. Through the process of accepting deposits and making loans, banks increase the money supply within an economy.

Banks use customers' deposits to extend credit to borrowers, while maintaining a fraction as reserves according to the reserve ratio. Through this lending process and the subsequent deposits made back into the banking system, banks can significantly amplify the amount of money circulating, as depicted by the money multiplier.

• This cycle of deposit and re-deposit underscores the essential role of the banking system in economic growth and monetary policy.
• By managing excess reserves and applying the reserve ratio, banks not only maintain liquidity but also fuel economic productivity through increased lending and investment opportunities.

Understanding how the banking system functions helps in comprehending broader economic mechanisms and the central role of banking institutions in fostering economic health.