Question

What will happen to the money supply under the following circumstances in a checkable-deposits-only system? a. The required reserve ratio is \(25 %\), and a depositor withdraws $$ 700\( from his checkable bank deposit. b. The required reserve ratio is \)5 %, and a depositor withdraws $$ 700 from his checkable bank deposit. c. The required reserve ratio is \(20 %, and a customer deposits $$ 750\) to her checkable bank deposit. d. The required reserve ratio is \(10 %, and a customer deposits $$ 600\) to her checkable bank deposit.

Short answer

For A, the money supply decreases by \$700. For B, it decreases by \$700 but with a higher potential impact. For C, it potentially increases by up to \$3,750. For D, it potentially increases by up to \$6,000.

Step-by-step solution

Understanding the Money Creation Process

The money supply is affected by the deposit and withdrawal activities in banks due to the fractional reserve banking system. Banks are required to keep a fraction of deposits as reserves and can lend out the rest, a process that can increase the money supply.

Calculating the Impact of a Withdrawal with a 25% Reserve Ratio

A withdrawal decreases the assets and liabilities of a bank. The reserve ratio does not directly change the amount withdrawn, but it affects how much money the bank can lend out. With a 25% reserve ratio, for every dollar deposited, banks can lend out \(75\text{ cents}\). When \$700 is withdrawn, the bank loses \$700 of its reserves, and the money supply initially decreases by \$700.

Calculating the Impact of a Withdrawal with a 5% Reserve Ratio

A 5% reserve ratio allows the bank to lend out \(95\text{ cents}\) of every dollar deposited. With \$700 withdrawn, the reserves decrease by \$700, and since the bank can lend out more with a lower reserve ratio, the potential decrease in money supply is larger than that for a 25% reserve ratio.

Calculating the Impact of a Deposit with a 20% Reserve Ratio

A deposit increases bank reserves and allows the bank to create money through lending. With a 20% reserve ratio, for every dollar deposited, the bank must hold \(20\text{ cents}\) and can lend out \(80\text{ cents}\). Depositing \$750 increases the potential money supply by up to \$3,750, calculated using the money multiplier formula \(Money\ Multiplier = \frac{1}{Reserve\ Ratio}\).

Calculating the Impact of a Deposit with a 10% Reserve Ratio

Likewise, a deposit with a 10% reserve ratio similarly increases the potential for money creation. The bank keeps \(10\text{ cents}\) for every dollar deposited and lends out \(90\text{ cents}\). A \$600 deposit could potentially result in a \$6,000 increase in money supply, using the money multiplier.

Key concepts

Reserve Ratio

The reserve ratio is a critical regulatory requirement for banks operating under a fractional reserve banking system. It is defined as the percentage of depositors' balances that banks must have on hand in the form of cash or as deposits with the central bank. For example, if the reserve ratio is set at 25%, this means that for every dollar deposited, the bank is obligated to keep 25 cents in reserve and is free to lend out the remaining 75 cents.

The reserve ratio impacts the amount of money banks can create through lending. A higher reserve ratio like 25% limits the bank's ability to lend, potentially slowing the expansion of the money supply. Conversely, a lower reserve ratio, such as 5%, means that banks can lend a larger portion of their deposits, increasing their ability to 'create' money and expand the money supply. This foundational element of the banking system plays a crucial role in influencing overall economic activity by controlling the liquidity available to businesses and consumers through loans.

Bank Deposits and Withdrawals

In the context of bank operations, deposits and withdrawals are everyday transactions that have a deeper impact on the overall economy than one might initially suspect. When a customer deposits money into a bank, the bank's reserves increase, giving the bank more capacity to issue loans. This action adheres to the principles of fractional reserve banking, where banks only keep a fraction of the total deposits on hand as reserves.

Withdrawals, on the other hand, have the opposite effect. When a customer withdraws money, like withdrawing $700 from their account, this reduces the bank's reserves. In a system with a 25% reserve ratio, each dollar withdrawn could mean potentially less money circulated through loans, thus decreasing the money supply. Hence, understanding the effects of deposits and withdrawals on a bank's reserve position is essential for grasping how money supply can fluctuate in an economy based on the actions of individual bank customers.

Money Multiplier

The money multiplier is a fundamental concept that elucidates how deposits can multiply throughout the banking system, thereby expanding the money supply. It represents the maximum amount of commercial bank money that can be created, given a certain level of central bank money. Mathematically, the money multiplier is the reciprocal of the reserve ratio: \[ Money\ Multiplier = \frac{1}{Reserve\ Ratio} \].

For instance, with a reserve ratio of 20%, the money multiplier is 5 (\(\frac{1}{0.20} = 5\)). This implies that for every dollar deposited in a bank, up to five dollars can be generated in the economy through the banks' lending processes, as banks keep 20 cents of every dollar and lend out the remaining 80 cents. However, the actual impact on the money supply also depends on other factors, such as the currency drain ratio and the willingness of banks to lend and of borrowers to borrow. Effectively, the money multiplier is a powerful tool for understanding the potential amplification effects of banking operations on the money supply within an economy.