Question

15. Using a deposit of $400,000 and a R.R. - .4, show how a 3 bank model creates money. Also calculate the total money that could be created by the entire banking system. (5pts) Bank A Bank B Bank C. AL

Answer 1

For a bank, deposits are a liability because, they have to be paid back and Loans are an Asset as they will get that money back.

R.R is the reserve ratio which every bank has to maintain. So as per this 4% of the total deposits of the bank has to be maintained as a reserve and the rest can be given out as loans to customers.

So, if Mr.X deposits $400,000 in Bank A, then the liabilities side of the bank will be $400,000 as Deposits and Reserves on the Assets side will $400,000.

Bank A
Assets	Amount	Liabilities	Amount
Reserves	400,000	Deposits'	400,000

Now, if Bank A maintains the Reserve Ratio of 4% which is $16,000, the rest $384,000 can be given out as Loans.

So, suppose, this amount is given as a Loan to Ms.Y , she will deposit the cheque in Bank B. Now, the deposits of Bank B will increase and the Reserves of Bank A will reduce and the loans will increase.

Bank A					Bank B
Assets	Amount	Liabilities	Amount		Assets	Amount	Liabilities	Amount
Reserves	400,000	Deposits'	400,000		Reserves	384,000	Deposit	384,000
Loan to Ms.Y	384,000
Total	784,000		400,000		Total	384,000		384,000

Now, as you can see , because of the loan given to Ms. Y, the money supply has increased from $400,000 to $784,000.

Similarly, Mr.Z will take a loan from Bank B. So, Bank B can give out only $368,640 as 4% of $384,000 which is $15,360 needs to be kept as reserves.

Now the balance of all banks will look like this ,

Bank A

Bank B

Bank C

Assets

Amount

Liabilities

Amount

Assets

Amount

Liabilities

Amount

Assets

Amount

Liabilities

Amount

Reserves

400,000

Deposits'

400,000

Reserves

15,360

Deposit

384,000

Reserves

368,640

Deposit

368,640

Loan to Ms.Y

384,000

Loan to Mr.Z

368,640

Total

784,000

400,000

Total

384,000

384,000

Total

368,640

368,640

So, now the money supply has increased from $784,000 to $1,152,640 ( 400,000 + 384,000+368,640)

In this manner , the banks create money . Now, since there are many banks present in the financial system and banks have to maintain only a part of the deposits as reserves, loans given out end up as deposits in other banks. This way the money supply essentially increases.