5 The Money Creation Processsuppose First Main Street Bank Second Re ✓ Solved

5. The money creation process Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 10%. Alex, a client of First Main Street Bank, deposits 0,000 into his checking account at First Main Street Bank. Complete the following table to reflect any changes in First Main Street Bank's T-account (before the bank makes any new loans).

Assets Liabilities Reserves 0,000 Deposits 0,000 Complete the following table to show the effect of a new deposit on excess and required reserves when the required reserve ratio is 10%. Hint : If the change is negative, be sure to enter the value as negative number. Amount Deposited Change in Excess Reserves Change in Required Reserves (Dollars) (Dollars) (Dollars) 500,000 Now, suppose First Main Street Bank loans out all of its new excess reserves to Susan, who immediately uses the funds to write a check to Raphael. Raphael deposits the funds immediately into his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Clancy, who writes a check to Becky, who deposits the money into her account at Third Fidelity Bank.

Third Fidelity lends out all of its new excess reserves to Eileen in turn. Fill in the following table to show the effect of this ongoing chain of events at each bank. Enter each answer to the nearest dollar. Increase in Deposits Increase in Required Reserves Increase in Loans (Dollars) (Dollars) (Dollars) First Main Street Bank Second Republic Bank Third Fidelity Bank Assume this process continues, with each successive loan deposited into a checking account and no banks keeping any excess reserves. Under these assumptions, the 0,000 injection into the money supply results in an overall increase of 500,000, 4,500,000, 5,000,000 in demand deposits.

6. The reserve requirement, open market operations, and the money supply Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of 0. Determine the money multiplier and the money supply for each reserve requirement listed in the following table. Reserve Requirement Simple Money Multiplier Money Supply (Percent) (Dollars) , 2.5, 4, 10, , 1250, 2000, 5000, ( , 2.5, 4, 10, , 1250, 2000, 5000, 12500) A lower reserve requirement is associated with a (LARGER, SMALLER) money supply.

Suppose the Federal Reserve wants to increase the money supply by 0. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to (BUY, SELL) worth of U.S. government bonds. Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%.

This increase in the reserve ratio causes the money multiplier to (RISE, FALL) to ( 1, 2.5, 4, 10). Under these conditions, the Fed would need to (BUY, SELL) worth of U.S. government bonds in order to increase the money supply by 0. Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply. The Fed cannot prevent banks from lending out required reserves.

The Fed cannot control the amount of money that households choose to hold as currency. The Fed cannot control whether and to what extent banks hold excess reserves. 8. Problems and Applications Q8 Suppose that people expect inflation to equal 5 percent, but in fact, prices rise by 7 percent. Which of the following groups or individuals are hurt by this unexpectedly high inflation rate?

Check all that apply. The government A college that has invested some of its endowment in government bonds that are not indexed Treasury bonds A homeowner with a fixed-rate mortgage A union worker in the second year of a labor contract 9. The level of prices and the value of money Suppose the price level reflects the number of dollars needed to buy a basket of goods containing one cup of coffee, one donut, and one newspaper. In year one, the basket costs .00. In year two, the price of the same basket is .00.

From year one to year two, there is INFLATION, DEFLATION at an annual rate of 1.00% 1.11% 1.25%, 11.11% 12.50%. In year one, .00 will buy 0.11, 0.13, 4.5, 8, 9 baskets, and in year two, .00 will buy 0.11, 0.13, 4.5, 8, 9 baskets. This example illustrates that, as the price level falls, the value of money RISE, FALL, REMAIN the SAME. 10. Using money creation to pay for government spending Consider Tralfamadore, a hypothetical country that produces only cakes.

In 2016, a cake is priced at .00. Complete the first row of the table with the quantity of cakes that can be bought with 0. Hint : In this problem, assume it is not possible to buy a fraction of a cake, and always round down to the nearest whole cake. For example, if your calculations result in 1.5 cakes, the answer should be 1 cake. Year Price of a Cake Cakes Bought with 0 (Dollars) (Quantity) .

Suppose the government of Tralfamadore cannot raise sufficient tax revenue to pay its debts. In order to meet its debt obligations, the government prints money. As a result, the money supply rises by 20% by 2017. Assuming monetary neutrality holds, complete the second row of the table with the new price of a cake and the new quantity of cakes that can be bought with 0 in 2017. The impact of the government's decision to raise revenue by printing money on the value of money is known as the CLASSICAL DICHOTOMY, FISHER EFFECT, INFLATION TAX, VELOCITY OF MONEY.

11. Identifying costs of inflation Andrew manages a grocery store in a country experiencing a high rate of inflation. He is paid in cash twice per month. On payday, he immediately goes out and buys all the goods he will need over the next two weeks in order to prevent the money in his wallet from losing value. What he can't spend, he converts into a more stable foreign currency for a steep fee.

This is an example of the MENU COST, SHOE-LEATHER COST, UNIT-OF-ACCOUNTS-COST of inflation. 12. Inflation-induced tax distortions Musashi receives a portion of his income from his holdings of interest-bearing U.S. government bonds. The bonds offer a real interest rate of 2.5% per year. The nominal interest rate on the bonds adjusts automatically to account for the inflation rate.

The government taxes nominal interest income at a rate of 10%. The following table shows two scenarios: a low-inflation scenario and a high-inflation scenario. Given the real interest rate of 2.5% per year, find the nominal interest rate on Musashi's bonds, the after-tax nominal interest rate, and the after-tax real interest rate under each inflation scenario. Inflation Rate Real Interest Rate Nominal Interest Rate After-Tax Nominal Interest Rate After-Tax Real Interest Rate (Percent) (Percent) (Percent) (Percent) (Percent) 2....5 Compared with higher inflation rates, a lower inflation rate will DECREASE, INCREASE the after-tax real interest rate when the government taxes nominal interest income.

This tends to ENCOURAGE, DICOURAGE saving, thereby INCREASING, DECREASING the quantity of investment in the economy and INCREASING, DECREASING the economy's long-run growth rate. 13. Problems and Applications Q5 You take 0 you had kept under your mattress and deposit it in your bank account. Suppose this 0 stays in the banking system as reserves and banks hold reserves equal to 12.5 percent of deposits. The total amount of deposits in the banking system increases by , and the money supply increases by image2.wmf image3.wmf image1.wmf

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The Money Creation Process

Introduction to the Money Creation Process

The money creation process in a banking system involves banks lending out a proportion of their deposits, thus multiplying the amount of money circulating in the economy. This is influenced by the required reserve ratio set by the central bank. When an individual deposits money into a bank, the bank must hold a fraction of that deposit in reserve and is allowed to lend out the remainder, effectively creating more money through loans that are subsequently deposited into other banks.

Initial Bank Scenario

Let's analyze the initial scenario in which Alex deposits 0,000 into his checking account at First Main Street Bank. The required reserve ratio is set at 10%.

First Main Street Bank T-account

| Assets | Liabilities |
|------------------------|------------------------|
| Reserves: 0,000 | Deposits: 0,000 |
Change in Reserves and Excess Reserves
- Required Reserves: 10% of 0,000 = ,000
- Excess Reserves: 0,000 - ,000 = 0,000
The bank’s required reserves will be reflected as follows:
| Amount Deposited | Change in Excess Reserves | Change in Required Reserves |
|----------------------|-------------------------------|----------------------------------|
| 0,000 | 0,000 | ,000 |

Chain of Events in Money Creation

Now, let's examine what happens as First Main Street Bank loans out its new excess reserves to Susan, who writes a check to Raphael. Raphael then deposits the funds at Second Republic Bank. This process continues with the subsequent banks.
1. First Main Street Bank:
- Increase in Loans: 0,000 (Susan's loan)
- Increase in Deposits: 0,000 (Alex's initial deposit remains)
- Reserves after loaning: ,000
- Required Reserves: ,000 (10% of total deposits)
2. Second Republic Bank (receiving deposits from Raphael):
- Deposits: 0,000
- Required Reserves: ,000 (10% of 0,000)
- Excess Reserves: 5,000
- Loans Made to Clancy: 5,000
- Total Deposits: 0,000 + 5,000 = 5,000
3. Third Fidelity Bank (receiving deposits from Clancy):
- Deposits: 5,000
- Required Reserves: ,500 (10% of 5,000)
- Excess Reserves: 4,500
- Loans Made to Eileen: 4,500
- Total Deposits: 5,000 + 4,500 = 9,500

Summary of Effects on Each Bank

The following table summarizes the effects of the demonstrated chain of events:
| Bank | Increase in Deposits | Increase in Required Reserves | Increase in Loans |
|------------------------|----------------------|-------------------------------|--------------------------|
| First Main Street Bank | 0,000 | ,000 | 0,000 |
| Second Republic Bank | 0,000 | ,000 | 5,000 |
| Third Fidelity Bank | 5,000 | ,500 | 4,500 |

Continuing the Money Creation Cycle

If these events repeat multiple times, the total money supply can significantly increase from the initial deposit of 0,000 due to the multiplicative effect of lending.

The Money Multiplier

The money multiplier (MM) is calculated as:
\[
MM = \frac{1}{\text{Required Reserve Ratio}}
\]
Given our reserve ratio of 10% (0.10):
\[
MM = \frac{1}{0.10} = 10
\]
This means a 0,000 deposit can theoretically increase the money supply by ,000,000 (10 times the initial deposit).

Changes in Reserve Requirements and Their Effects

Given various reserve requirements, we can determine the money multiplier and money supply in a controlled environment where the banking system has total reserves of 0.
| Reserve Requirement (%) | Money Multiplier | Money Supply (Dollars) |
|-------------------------|------------------|-------------------------|
| 2.5 | 40 | ,000 |
| 4 | 25 | ,500 |
| 10 | 10 | ,000 |
As the reserve requirement decreases, the money multiplier increases, allowing more money to be created from the same amount of reserves. A lower reserve requirement is typically associated with a larger money supply.

Open Market Operations for Money Supply Control

Should the Federal Reserve (Fed) wish to increase the money supply by 0 with a reserve requirement of 10%, it would need to buy U.S. government bonds worth 0 to inject funds into the economy.
If banks increase their reserves from 10% to 25%, the money multiplier would decrease (approx. 4) leading to a need for the Fed to buy more bonds to achieve the same monetary increase.

Inflation and its Effects

Inflation can have various surprising effects on different economic agents. For instance, individuals or entities that expect an inflation rate but experience a higher rate—such as a government or fixed-rate mortgage holder—will be disadvantaged as their real value erodes quicker than anticipated (Mankiw, 2021).

Conclusion

Understanding the money creation process, the role of reserve requirements, and the implications of monetary policy actions like open market operations is crucial for navigating the complexities of modern economies. The mechanisms of banking significantly affect overall economic stability and growth, impacting everything from inflation rates to the value of individual savings.

References

1. Mankiw, N. G. (2021). Principles of Economics. Cengage Learning.
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4. Friedman, M. (1969). The Optimum Quantity of Money. The Journal of Money, Credit and Banking, 1(1), 1-14.
5. Taylor, J. B. (1993). Discretion versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214.
6. Gates, W. R. (2020). Money, Banking, and the Federal Reserve. Federal Reserve Bank of St. Louis.
7. Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press.
8. Romer, D. (2019). Advanced Macroeconomics. McGraw-Hill Education.
9. Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. Harcourt Brace Jovanovich.
10. Bernanke, B. S., & Gertler, M. (1995). Inside the Black Box: The Credit Channel of Monetary Policy Transmission. Journal of Economic Perspectives, 9(4), 27-48.