Chapter 12: Problem 1

Suppose banks keep no excess reserves and no individuals or firms hold on to cash. If someone suddenly discovers $\$ 12$ million in buried treasure and deposits it in a bank, explain what will happen to the money supply if the required reserve ratio is 10 percent.

Short Answer

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Answer: The money supply will increase by $120 million.

Step by step solution

Understand Required Reserve Ratio and Money Multiplier

The required reserve ratio is the proportion of a bank's deposits that it must hold as reserves. In this exercise, the required reserve ratio is 10 percent. The money multiplier is the inverse of the reserve requirement, which indicates how much new money the banking system can create for each dollar of reserves. In this case, the money multiplier is $1/\text{reserve requirement} = 1/0.1 = 10$.

Calculate the Initial Deposit

The initial deposit in this exercise is the $12$ million dollars the person discovers in buried treasure and deposits it in a bank. This is the starting point for our calculation: $\$ 12,000,000$.

Calculate New Money Created

Using the money multiplier and the initial deposit, we can calculate the new money created in the banking system. New money created = Money Multiplier × Initial Deposit = $10 × 12,000,000 = \$ 120,000,000$.

Determine Change in Money Supply

The change in the money supply due to this deposit is equal to the new money created calculated in Step 3. In this case, the money supply will increase by $ \$ 120,000,000$ when the person deposits the discovered money into the bank. So, the money supply will increase by $\$ 120$ million when the bank receives the new deposit of $\$ 12$ million, and the required reserve ratio is 10 percent.

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Suppose banks keep no excess reserves and no individuals or firms hold on to cash. If someone suddenly discovers \(\$ 12\) million in buried treasure and deposits it in a bank, explain what will happen to the money supply if the required reserve ratio is 10 percent.