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Chapter 25: Problem 12

Suppose you deposit \(\$ 2,000\) in currency into your checking account at a branch of Bank of America, which we will assume has no excess reserves at the time you make your deposit. Also assume that the required reserve ratio is 0.20 , or 20 percent. a. Use a T-account to show the initial effect of this transaction on Bank of America's balance sheet. b. Suppose that Bank of America makes the maximum loan it can from the funds you deposited. Using a T-account, show the initial effect of granting the loan on Bank of America's balance sheet. Also include on this T-account the transaction from part (a). c. Now suppose that whoever took out the loan in part (b) writes a check for this amount and that the person receiving the check deposits it in a branch of Citibank. Show the effect of these transactions on the balance sheets of Bank of America and Citibank after the check has been cleared. (On the T-account for Bank of America, include the transactions from parts (a) and (b).) d. What is the maximum increase in checking account deposits that can result from your \(\$ 2,000\) deposit? What is the maximum increase in the money supply? Briefly explain.

Short Answer

Expert verified
The maximum potential increase in both the checking account deposits and the money supply resulting from an initial deposit of \$2000 is \$10000.

Step by step solution

01

Initial Deposit

First, calculate the initial effect of the deposit on Bank of America's balance sheet.The initial $2000 deposit increases both its assets (reserves) and liabilities (checking account deposits). The T-account is:\[\begin{{array}}{{ll}}\text{{Assets (reserves)}} & \text{{Liabilities (deposits)}} \+ \$2000 & + \$2000 \\end{{array}}\]
02

Maximum Loan

Next, we calculate the maximum loan the bank can give out from the deposit according to the reserve requirement (20%).The bank can loan out the amount of the deposit minus the required reserves. The reserves are 20% of \$2000, i.e. \$400, hence the bank can loan \$1600. The T-account now, including the deposit and the loan, is:\[\begin{{array}}{{ll}}\text{{Assets (reserves + loans)}} & \text{{Liabilities (deposits)}} \+ \$2000 (\$400 + \$1600) & + \$2000 \\end{{array}}\]
03

Check Deposit in Citibank

Assuming the borrower writes a check for the loan amount and it's deposited into Citibank, show the effect of this transaction.Transaction reduces Bank of America's reserves by the loan amount, and increases Citibank's. Bank of America's T-account becomes:\[\begin{{array}}{{ll}}\text{{Assets (reserves + loans)}} & \text{{Liabilities (deposits)}} \\$400 - \$1600 & \$2000 \\end{{array}}\]Citibank's T-account becomes:\[\begin{{array}}{{ll}}\text{{Assets (reserves)}} & \text{{Liabilities (deposits)}} \+ \$1600 & + \$1600 \\end{{array}}\]
04

Maximum Increase in Checking Accounts and Money Supply

Find the total increase in checking account deposits.According to the money multiplier theory (where multiplier = 1/reserve requirement), the maximum increase in checking deposits is deposit * multiplier. The multiplier is 1/0.2 = 5, hence maximum increase in deposits is \$2000 * 5 = \$10000.For the maximum increase in money supply, since all the newly created deposits are also part of the money supply, the increase is also \$10000.

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Most popular questions from this chapter

In a column in the Wall Street Journal, Kevin Brady, a member of Congress from Texas, stated, "To get Congress to pass the Federal Reserve Act [in \(1913,\) President Woodrow] Wilson had to retain the support of \(\ldots\) northeastern lawmakers while convincing southern and western Democrats that legislation would not \(\ldots\) create a [single] central bank. Wilson's ingenious solution was federalism." Explain what Congressman Brady meant when he stated that Woodrow Wilson used "federalism" to convince Congress to pass the Federal Reserve Act.

Briefly explain whether you agree with the following statement: "I recently read that more than half of the money the government prints is actually held by people in foreign countries. If that's true, then the United States is less than half as wealthy as government statistics indicate."

What is hyperinflation? Why do governments sometimes allow it to occur?

Give the formula for the simple deposit multiplier. If the required reserve ratio is 20 percent, what is the maximum increase in checking account deposits that will result from an increase in bank reserves of \(\$ 20,000 ?\) Is this maximum increase likely to occur? Briefly explain.

During the years from 2010 to 2016 , the average annual growth rate of \(\mathrm{M} 1\) was 10.3 percent, while the inflation rate as measured by the GDP deflator averaged 1.6 percent. Are these values consistent with the quantity equation? If you would need additional information to answer, state what the information is. Are the values consistent with the quantity theory of money? Briefly explain.
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