Yesterday Bank A had no excess reserves. Today it received a new deposit of \(\$ 4,000\). a. If the bank maintains a reserve requirement of 2 percent, what is the maximum loan that Bank \(A\) can make? b. What is the maximum amount by which the money supply can be increased as a result of Bank A's new loan?

The reserve requirement is a regulation that sets the minimum fraction of customer deposits that each bank must keep on hand as reserves, instead of lending them out. The reserve requirement ratio is decided by a country's central bank and is crucial for controlling the money supply within the economy.

For instance, in the exercise scenario, the central bank has set a reserve requirement of 2 percent. This means Bank A must hold 2 percent of any deposit as reserves. With a deposit of \(\$4,000\), the calculation for the required reserves is straightforward: \(\$4,000 \times 0.02 = \$80\). This small ratio implies that a large portion of the deposit can be loaned out, which in turn plays a significant role in money creation through the banking system.

Excess reserves are the funds that a bank has beyond the required minimum reserves. They are pivotal for the bank's liquidity and its ability to make new loans.

In the scenario provided, after setting aside the required reserve (\(\$80\)), Bank A is left with \(\$3,920\) in excess reserves. This is the potential amount that the bank can use to extend loans or invest in other profitable ventures. Calculating excess reserves is an important step because it determines how much money a bank can inject into the economy through lending. \(Excess Reserves = Deposit Amount - Required Reserves\).

The banking system refers to the network of financial institutions that accept deposits, lend money, and provide financial services. It plays a crucial role in the economy by facilitating transactions, providing credit, and managing the money supply.

As shown in the solution steps, when Bank A receives a new deposit, it impacts the money supply by lending out its excess reserves. Each new loan made can be deposited into another bank, creating more reserves and allowing for additional loans. This domino effect is the basis of the money creation process within the banking system, emphasizing the importance of maintaining equilibrium to ensure economic stability.

The money supply is the total amount of money available in an economy, consisting of cash, coins, and balances held in checking and savings accounts among other forms. The central bank uses several tools to influence the money supply, including reserve requirements.

Using the money multiplier formula \(Money Multiplier = 1 / Reserve Requirement\), we see how slight alterations in the reserve requirement have magnified effects on the money supply. In the exercise, a money multiplier of 50 indicates that for every dollar held in reserve, \$50 can be created in the broader economy. Thus, with the initial \(\$4,000\) deposit, up to \(\$200,000\) could be added to the money supply, demonstrating the power of the banking system in expanding economic activity.