Assume that the Bank of Ecoville has the following balance sheet and the Fed has
ID: 1185915 • Letter: A
Question
Assume that the Bank of Ecoville has the following balance sheet and the Fed has a 10% reserve requirement in place:
Balance Sheet for Ecoville International Bank
ASSETS LIABILITIES
Cash $33,000 Demand Deposits$99,000
Loans 66,000
Required:
Now assume that the Fed lowers the reserve requirement to 8%.
1) What is the maximum amount of new loans that this bank can make?
2)Assume that the bank makes these loans. What will the new balance sheet look like?
3)By how much has the money supply increased or decreased?
4)If the money multiplier is 5, how much money will ultimately be created by this event?
5)If the Fed wanted to implement a contractionary monetary policy using reserve requirement, how would that work?
Explanation / Answer
The bank is only required to keep 10% of the demand deposits as reserves. 10% of $99000 is $9900. The bank can therefore make loans up to $99,000 - 9900 = $89,100. It has actually made loans worth $66,000. So even with no change in the required reserve ratios the bank can still make additional loans worth $23,100.
If the Fed reduces the required reserve ratio to 8%, the bank is now required to keep 8% of $99,000, or $7920. The bank can then make loans worth $99,000 - 7920 =$91,080.
The bank has already made actual loans worth $66,000 so it can further loan out $91,080-66,000 = $25,080.
If they made these loans, the balance sheet would look like this:
Assets
Cash: $7,920
Loans: $91,080
Liabilities
Demand Deposits: $99,000
If the bank actually loans out as much as allowed, then the initial increase in money supply is $25,080. The final increase when all rounds have been completed will be determined by the money multiplier that is given by 1/r, where r is the required reserve ratio. Given that r is 8%, the multiplier is 1/0.08 = 12.5. Hence, the increase in money supply is 12.5 x 25,080= $313,500.