Question

Assets		Liabilities
Total Reserves	$50,000	Demand Deposits	$180,000
U.S. Government Bonds	$110,000
Loans	$20,000

Assume the balance sheet above is for Eastlandia National Bank. The reserve requirement is 20%.

1. Given the current situation, how much money can Eastlandia National Bank lend to borrowers if it wants to keep all of its bonds?
2. Based on your answer in part (a), calculate how much additional money can Eastlandia National Bank create? (Calculate means show your work.)
3. Explain two reasons why money creation may not increase by the amount you identified in part (b).

Answer 1

A.

Maximum money to be lended by Eastlandia National Bank = Total reserve - required reserve

Maximum money to be lended by Eastlandia National Bank = 50000 - 20%*180000

Maximum money to be lended by Eastlandia National Bank = $14000

B.

Additional money to be created = 14000*(1/required reserve ratio)

Additional money to be created = 14000*(1/20%)

Additional money to be created = $70000

C.

Two reasons are as follows:

1. People borrowing money, may keep some part of it at home and deposit the remaining amount. It will create leakage and money multiplier will not show its full impact.

2. People will borrow, but spend on the basis of their marginal propensity to consume. It will also not make money creation to take place as it is shown by the money multiplier.