Wednesday 28 October

Suppose a bank is required to hold reserves equal to 20% of its liabilities. Your second cousin in Russia sends you by Fedex $10,000 in currency he has been keeping under his mattress and asks you to deposit it in the bank. You do.

  1. What happens to the bank's required reserves?

    2. Its liabilities (deposits) have increased by $10,000, so its required reserves increase by that much times the required reserve ratio, 20%; so required reserves increase $2,000.

  2. How much extra does the bank now have it can loan out?

    3. Currency is reserves, but only $2,000 of the deposit is required as reserves; so the other $8,000 is available to loan out.

  3. With a 20% required reserve ratio, each $1 of reserves can support how many $'s of liabilities?

    4. A 20% required reserve ratio implies the $100 of liabilities requires $20 of reserves; so turning that around, each $1 of reserves can support $5 of liabilities (one divided by the required reserve ratio).

  4. If the first bank makes the maximum loan it can, and then that loan results in a bank deposit equal to the loan (e.g. used to buy a car, the dealer deposits the proceeds of selling the car), and the new bank makes the maximum loan it can, and so on, what is the maximum change to the US money supply as a result of the $10,000 in currency coming back from Russia?

No 3 showed each $1 of reserves can support $5 of liabilities, i.e. deposits; deposits in checking accounts are part of the money supply. The $10,000 of currency going in the bank increases reserves by $10,000, so the US money supply could increase by as much as five times that, i.e. $50,000.

If the required reserve ratio had been, say, 40%, the answer to 3. would have been $2.50 and to 4., $25,000; if the required reserve ratio had been 12.3%, $8 and $80,000.