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

The \$100 of initial excess reserves would cause a larger total amount of money creation in Canada.

Step-by-step solution

Understand the Reserve Ratio

The reserve ratio is the fraction of deposits that banks are required to keep in reserve and not loan out. A 10% reserve ratio in Canada means banks can loan out 90% of deposits, while a 20% reserve ratio in the US means banks can loan out 80% of deposits.

Determine the Money Multiplier

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

Calculate Potential Money Creation

To determine the potential total money creation from an initial excess reserve of \$100, we multiply the excess reserve by the money multiplier. In Canada, the potential total money creation is \( 100 \times 10 = 1000 \) dollars. In the US, the potential total money creation is \( 100 \times 5 = 500 \) dollars.

Compare the Results and Conclude

The potential money creation in Canada is \\(1000, which is larger than the \\)500 in the United States. This indicates that the initial \$100 of excess reserves can cause a larger total amount of money creation in Canada.

Key concepts

Money Multiplier

The money multiplier is a crucial concept in understanding how the banking system can amplify the money supply. It represents the maximum amount of money that can be created for every unit of currency deposited in the banking system. The formula for the money multiplier is simple: it is the inverse of the reserve ratio. For example, if a country's reserve ratio is 10%, the formula would be: \[ \text{Money Multiplier} = \frac{1}{0.10} \]This calculates to a money multiplier of 10, meaning each dollar in reserves can support up to 10 dollars in deposits.

• Higher money multipliers mean banks can extend more loans from their reserves, multiplying the initial deposit amount through the economy.
• Fluctuations in the reserve ratio adjust the potential for money creation; a lower reserve ratio increases the money multiplier, while a higher ratio decreases it.

This concept helps in understanding why some economies can expand their money supply more rapidly than others, depending on their reserve requirements.

Excess Reserves

Excess reserves are the funds that banks hold over and above the required minimum reserves set by regulations. These reserves are pivotal in determining how much new money can be created in the economy. For example, if a bank receives a deposit of $100 and the reserve ratio is 10%, the bank must keep $10 but can lend out the remaining $90. This $90 is considered excess reserves because it is not required to be kept in reserve. Excess reserves are important because:

• They provide the liquidity banks need to issue loans, thereby contributing to the overall money supply.
• During times of economic uncertainty, banks might choose to hold onto excess reserves instead of lending, which can limit money creation.
• Changes in economic policy can influence banks to either hold onto or release these excess reserves into the economy.

Understanding excess reserves is vital for grasping how fluidity within the bank system impacts broader monetary growth.

Monetary Policy

Monetary policy encompasses the actions undertaken by a country's central bank to control the money supply and interest rates. These actions are intended to achieve macroeconomic goals such as controlling inflation, managing employment levels, and ensuring economic stability. Key tools used in monetary policy include:

• Open market operations: Buying and selling government securities to adjust the monetary base.
• Interest rate adjustments: Influencing the cost of borrowing money to either encourage or restrict spending and investment.
• Reserve requirements: Changing the percentage of reserves banks must hold, directly affecting the money multiplier and loan amounts.

Monetary policy directly ties to the reserve ratio and the money multiplier by adjusting how much money flows into the economy. For instance, lowering reserve requirements increases money supply as banks can lend more. Conversely, increasing them tightens money flow. Monetary policy is integral to maintaining economic equilibrium and responding to various economic challenges.