Question

Assume a target reserve ratio of 5%. A cheque for $40000 is drawn on an account in Bank B and deposited in a checking deposit in Bank A. Round your final answers to 2 decimal places, if necessary. Do not enter comma ", "or dollar sign (\$) while entering your answer.

a. By how much have the excess reserves of Bank A increased?
b. How much in the form of new loans is Bank A now able to extend to borrowers?
c. By how much have reserves of Bank B decreased?
d. By how much have excess reserves of Bank B decreased?
e. By how much has the money supply increased?

Answer 1

When a $40000 cheque is transferred from Bank B to Bank A with a reserve ratio of 5%, Bank A's excess reserves increase by $38000, which is the amount it can loan out. Bank B's reserves and excess reserves decrease by $40000. This creates the potential for an increased money supply starting with $40000 due to the money multiplier effect.

Step-by-step explanation:

Assuming a target reserve ratio of 5%, when a cheque for $40000 is drawn on Bank B and deposited in Bank A, Bank A's excess reserves increase by the amount of the deposit minus the required reserve. Since 5% of $40000 is $2000, the excess reserves have increased by $40000 - $2000 = $38000. Bank A can now extend new loans up to the amount of its excess reserves, which is $38000. The reserves of Bank B decrease by the full amount of the cheque, which is $40000. Simultaneously, the excess reserves of Bank B decrease by the same amount unless Bank B was holding excess reserves above the requirement before the cheque was drawn. As the new loans from Bank A are deposited in checkable (demand) deposit accounts, the potential money supply increases. Initially, it increases by the amount of the cheque, $40000. However, as Bank A extends new loans and those funds circulate, the increase in the money supply can be much larger due to the money multiplier effect.