Question

Initially, the Republic of Gorgonzola has no commercial banking system. To make trading easier and eliminate the need for barter, the government directs the central bank of Gorgonzola to put into circulation 5 million identical paper notes, called guilders. The central bank prints the guilders and distributes them to the people. At this point the Gorgonzolan money supply is 5 million guilders.

In order to keep the money safe, some Gorgonzolan entrepreneurs set up a system of commercial banks. When people need to make a payment, they can either withdraw their guilders or write a check on their account. Checks give the banks permission to transfer guilders from the account of the person paying by check to the account of the person to whom the check is made out. With a system of payments based on checks, the paper guilders need never leave the banking system, although they flow from one bank to another as a depositor of one bank makes a payment to a depositor in another bank. Deposits do not earn interest in this economy. Let’s suppose for now that people prefer bank deposits to cash and so deposit all of their guilders with the commercial banks.
Assume that initially, the Gorgonzolan commercial banks desire to hold reserves of 20 percent of deposits. Assume that the public holds no currency.
Instructions: Enter your responses as integer values.
a. The consolidated balance sheet of Gorgonzolan commercial banks after the initial deposits is:

Answer 1

In the absence of a commercial banking system and the introduction of 5 million guilders by the central bank, the consolidated balance sheet of the Gorgonzolan commercial banks shows 1 million guilders in reserves and 5 million guilders in deposits, with a reserve ratio of 20%.

Step-by-step explanation:

The student is asking about the balance sheet of Gorgonzolan commercial banks after they have received initial deposits amounting to 5 million guilders, with a reserve ratio of 20%. To construct the consolidated balance sheet, we need to make two entries: deposits from the public and reserves that the bank will hold. If all the guilders are deposited, the deposits would be 5 million guilders. With a reserve ratio of 20%, the banks will hold 1 million guilders in reserves (20% of 5 million guilders).

The remaining amount (80%) becomes excess reserves which can potentially be loaned out. Here is what the balance sheet would look like:

• Assets:
  • Reserves: 1 million guilders
• Liabilities:
  • Deposits: 5 million guilders

Please note that the balance sheet must balance, meaning that the total assets equal the total liabilities. As there is no currency held by the public and no interest earned on deposits, these factors do not affect the balance sheet in this scenario.