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. $$\$ 0$$ c.$$\$ 2 billion.$$ b. $$\$ 200 million.$$ d. $$\$ 20 billion.$$

Short answer

The maximum amount of new checkable-deposit money that can be created is \(\$20 \text{ billion}\).

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. With a reserve ratio of 10%, or 0.10, this indicates that for every dollar that is deposited, banks must keep 10 cents in reserve and can lend out 90 cents.

Identify Excess Reserves

Excess reserves are funds that banks have beyond the required reserves that can be used for lending. Here, the banks have excess reserves of \(\$2 \text{ billion}\).

Calculate the Money Multiplier

The money multiplier is the maximum amount of checkable deposits that can be created by the banking system from new reserves and is calculated using the formula \( \text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}} \). With a reserve ratio of 0.10, the money multiplier is \( \frac{1}{0.10} = 10 \).

Determine the Maximum Checkable Deposits

Multiply the excess reserves by the money multiplier to find the maximum new checkable deposits. Thus, \( 2 \text{ billion} \times 10 = 20 \text{ billion} \). This is the maximum amount of new checkable-deposit money that can be created by the banking system.

Key concepts

Excess Reserves

Excess reserves refer to the amount of funds that banks hold beyond what is required by the central bank's reserve requirement. Put simply, these are the excess funds that banks keep in reserve and are available to loan out to borrowers. In the exercise, banks have $2 billion in excess reserves.
This amount plays a critical role because it represents potential money that can be multiplied into new loans and, consequently, new checkable deposits in the economy. The more excess reserves a bank has, the more it can lend out.

• Excess reserves = total reserves - required reserves
• Excess reserves are crucial for economic expansion as they enable banks to lend more.

However, excess reserves sitting idle don't aid the economy directly. Their main importance lies in their potential to boost economic activity when they're lent out, thereby increasing overall money supply.

Money Multiplier

The money multiplier is a key concept in understanding how banks can expand the money supply. It represents the maximum amount of money that can be created in the banking system from an initial deposit, through the process of lending out and redepositing. It is calculated by the formula: \[\text{Money Multiplier} = \frac{1}{\text{Reserve Ratio}}\]
In our exercise, the reserve ratio is 10%, or 0.10, thus making the money multiplier \(\frac{1}{0.10} = 10\). This implies that for every dollar in reserves, up to 10 dollars can be created in deposit money.

• The multiplier effect allows banks to "create" money through lending, hence widening economic activity.
• This effect is pivotal in understanding how fractional reserve banking works.

The concept can sometimes be counterintuitive, as it shows how an initial amount can grow dramatically by moving through the banking system.

Checkable Deposits

Checkable deposits are the amounts kept by customers in their bank accounts that are readily available for writing checks or withdrawing. These deposits form a core part of the money supply and are typically subject to fractional reserve banking rules.
When banks use their excess reserves to issue loans, the recipients of these loans usually deposit these amounts back into the banking system as new checkable deposits. The creation of new checkable deposits increases with every cycle of no-reserve lending and results in a multiplied effect on the money supply.

• In our exercise, $20 billion in new checkable deposits can be created.
• These new deposits add to the liquidity in the economy as they can be used for an extensive range of transactions.

Understanding checkable deposits allows us to see how everyday banking activities contribute dynamically to the broader financial system.