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Chapter 25: Problem 4

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.

Short Answer

Expert verified
The formula for the simple deposit multiplier is the inverse of the reserve requirement ratio. With a required reserve ratio of 20 percent and an increase in bank reserves of $20,000, the maximum increase in checking account deposits that could occur is $100,000. However, this is unlikely to occur in the real world due to banks holding excess reserves and not all borrowed money being re-deposited.

Step by step solution

01

Derive the Formula for Simple Deposit Multiplier

Simple deposit multiplier is the inverse of the reserve requirement ratio. It is used to estimate the maximum amount that bank deposits can increase based on a new cash deposit. It is given as: \[ D = \frac{1}{RRR} \]where:\(D\) = deposit multiplier\(RRR\) = Reserve requirement ratio.
02

Application of Formula

Given the reserve requirement ratio is 20 percent or 0.2, the simple deposit multiplier (\(D\)) is calculated as:\[ D = \frac{1}{0.2} = 5 \]If there is an increase in bank reserves of $20,000, the maximum increase in checking account deposits can be calculated by multiplying this increase in reserves by the deposit multiplier:\[ Increase = D \times Increase\ in\ Reserves \]\[ Increase = 5 \times 20,000 = $100,000 \]
03

Logical Explanation

In an ideal situation, where all deposited money is lent out again and re-deposited, the process repeats itself and in theory, the maximum increase should occur. However, in reality, banks might hold excess reserves and not all individuals re-deposit the money they borrow. Therefore, the maximum increase is less likely to occur.

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Most popular questions from this chapter

An article in the American Free Press quoted Professor Peter Spencer of York University in England as saying, "This printing of money 'will keep the [deflation] wolf from the door." The same article quoted Ambrose Evans- Pritchard, a writer for the London-based newspaper The Telegraph, as saying, "Deflation has ... insidious traits. It causes shoppers to hold back. Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop." a. What is price deflation? b. What does Spencer mean by the statement "This printing of money 'will keep the [deflation] wolf from the door'"? c. Why would deflation cause "shoppers to hold back," and what does Evans- Pritchard mean by saying "Once this psychology gains a grip, it can gradually set off a self-feeding spiral that is hard to stop"?

If the money supply is growing at a rate of 6 percent per year, real GDP is growing at a rate of 3 percent per year, and velocity is constant, what will the inflation rate be? If velocity is increasing 1 percent per year instead of remaining constant, what will the inflation rate be?

Is the quantity theory of money better able to explain the inflation rate in the long run or in the short run? Briefly explain.

(Related to the Apply the Concept on page 890) During the German hyperinflation of the \(1920 \mathrm{~s}\), many households and firms in Germany were hurt economically. Do you think any groups in Germany benefited from the hyperinflation? Briefly explain.

Suppose that the Federal Reserve makes a \$10 million discount loan to First National Bank (FNB) by increasing FNB's account at the Fed. a. Use a T-account to show the effect of this transaction on FNB's balance sheet. Remember that the funds a bank has on deposit at the Fed count as part of its reserves. b. Assume that before receiving the discount loan, FNB has no excess reserves. What is the maximum amount of this \(\$ 10\) million that FNB can lend out? c. What is the maximum total increase in the money supply that can result from the Fed's discount loan? Assume that the required reserve ratio is 10 percent.
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