Question

Suppose banks keep no excess reserves and no individuals or firms hold on to cash. If someone suddenly discovers \(\$ 12\) million in buried treasure and deposits it in a bank, explain what will happen to the money supply if the required reserve ratio is 10 percent.

Short answer

Answer: The money supply will increase by $120 million.

Step-by-step solution

Understand Required Reserve Ratio and Money Multiplier

The required reserve ratio is the proportion of a bank's deposits that it must hold as reserves. In this exercise, the required reserve ratio is 10 percent. The money multiplier is the inverse of the reserve requirement, which indicates how much new money the banking system can create for each dollar of reserves. In this case, the money multiplier is \(1/\text{reserve requirement} = 1/0.1 = 10\).

Calculate the Initial Deposit

The initial deposit in this exercise is the \(12\) million dollars the person discovers in buried treasure and deposits it in a bank. This is the starting point for our calculation: \(\$ 12,000,000\).

Calculate New Money Created

Using the money multiplier and the initial deposit, we can calculate the new money created in the banking system. New money created = Money Multiplier × Initial Deposit = \(10 × 12,000,000 = \$ 120,000,000\).

Determine Change in Money Supply

The change in the money supply due to this deposit is equal to the new money created calculated in Step 3. In this case, the money supply will increase by \( \$ 120,000,000\) when the person deposits the discovered money into the bank. So, the money supply will increase by \(\$ 120\) million when the bank receives the new deposit of \(\$ 12\) million, and the required reserve ratio is 10 percent.

Key concepts

Required Reserve Ratio

The Required Reserve Ratio is a regulation set by a country's central bank that determines the minimum amount of reserves each commercial bank must hold in relation to its deposit liabilities. For example, if the required reserve ratio is 10%, this means that a bank must keep 10% of its total deposits in reserve and cannot use them for lending or investing.

This regulation ensures that banks have enough cash on hand to meet customer withdrawals and demands. By influencing how much money banks can create through lending, the reserve ratio directly impacts the money supply in the economy.

• It acts as a safety net for the banking system.
• It prevents banks from overextending themselves through loans.
• It helps stabilize the financial system during economic fluctuations.

The required reserve ratio is a powerful tool for central banks to control inflation and maintain economic stability.

Money Multiplier

The Money Multiplier is a key concept in understanding how banks can generate more money from an initial deposit. It refers to the factor by which the money supply expands through the process of banks lending out their reserves.

The calculation of the money multiplier is simple. It is the reciprocal of the required reserve ratio. So, if the reserve ratio is 10%, the money multiplier is \[1/0.1 = 10\]This means every dollar deposited into the banking system can theoretically expand the total money in circulation by 10 dollars.

• The multiplier effect illustrates how banks can "create" money.
• It shows the potential increase in money supply from an initial cash infusion.
• It is fundamental in monetary policy to stimulate or restrain economic activity.

Understanding the money multiplier helps in grasping the potential impact of changes in banking regulations on the broader economy.

Bank Reserves

Bank Reserves are the currency deposits that banks keep in their vaults, along with their balances in a central bank. These reserves are crucial for day-to-day banking operations as they allow banks to manage withdrawals and payment obligations.

Reserves are divided into two categories:

• Required Reserves: The portion that banks are mandated to hold by the central bank, as determined by the required reserve ratio.
• Excess Reserves: Any additional reserves that banks choose to hold over the required minimum.

Bank reserves act as financial cushions, providing banks with the liquidity necessary to cover unexpected demands. The amount of reserves also represents a tool for central banks to manage monetary policy, because they can influence the level of reserves through open market operations or changes in the required reserve ratio.

Maintaining adequate reserves is essential for each bank to ensure smooth operations and maintain trust with its customers.