Question

5. Suppose the FED buys $1 million bonds from a bank. Assume that the public does not want to hold any additional currency. a. what is the total increase in deposits in the economy if all banks keep 2% excess reserves (i.e. in addition to the 10% required by law)? (10 points) b. Describe the two first steps of the deposit creation process within the banking system. (10 points)

Answer 1

When FED buys $1 million bonds from a bank, it infuses $1 million into the banking system. This amount will lead to multiple increase in bank deposits.

Banks loans out 100% of its excess reserves. And since we assume that public doesn't want ti hold additional cash, thus the amount loaned out by bank is as it is gets redeposited into banking system.

a. Required reserve ratio(RRR) by law = 10%

All banks keep RRR = 10%+2%= 12%

As we know, DEPOSIT MULTIPLIER is = 1/RRR = 1/0.12

Total increase in deposit in economy = initial deposit * deposit multiplier = $1,000,000 * 1/0.12 = $8,333,333.33

b. 1st step of deposit creation goeas as follows:

After initial deposit of $1 million, banks loan out the excess reserve amount.

Excess reserves = actual reserves - required reserves = $1,000,000 - 0.12($1,000,000) = $880,000

Therefore, bank loans out initial deposit + excess reserve=$1,880, 000

2nd step of deposit creation is as follows :

Boun's balance shet ter L deposit reatin AssE Ts LIABILITIES deposits 1,880 pUD Bonds Loans +4 ,3t,D

Excess reserves = $1,000,000 - 0.12($1,880,000) = $774,400

Banks loan out = $1,880,000+774,400 = $2,654,400

Baue's balance Snut ater 2M derosit reabibn AsSETs LIABILITIES | checking depositata 2,0544m Resuwes Bonds + Looo ,ơro Loans 2,654,40D

Final deposit creation in banking system is as follws:

ance tex iual deposit creatisn ASSETS LIABILITIES deposti +$8 ,333 3333 Bonds Loans48,333,333-33