Final answer:
Initial deposit of $800 in a bank with a 5% reserve ratio leads to a repeated process where each subsequent round sees 95% of the previous amount being loaned out. Summing up the amounts loaned out after each round gives us the total additional deposits created. The total increase in money supply after five rounds is a sum of these additional deposits.
Step-by-step explanation:
Understanding the Money Creation Process in Banking
When an individual depositor deposits $800 in a bank with a 5% reserve ratio, and assuming no excess reserves or cash holdings outside the bank, the process of money creation begins. In round 1, the bank keeps 5% ($40) as reserves and can lend out the remaining 95% ($760). The next person who receives the $760 can then deposit it into their own bank, which keeps 5% ($38) and lends out $722. This process continues for each subsequent round.
In round 3, the bank would lend out 95% of $722, which is $685.90, and in round 4, they can lend 95% of $685.90, which is $651.605. Calculating these amounts for each round and summing them up gives us the total additional deposits created over the five rounds. Given that the initial deposit was $800, the formula to calculate the total increase in deposit after 'n' rounds is given by the initial deposit multiplied by [(1 - reserve ratio) ^ n], until the additional amount becomes negligible.
Here's a summary of the additional deposits created in each round:
- Round 1: $760.00
- Round 2: $722.00
- Round 3: $685.90
- Round 4: $651.605
- Round 5: (Step is repeated similarly)
Total increase in money supply after five rounds would be the sum of these additional deposits plus the initial $800. The potential total money supply created from the initial deposit utilizing the money multiplier (which is 1/reserve ratio), illustrates how the banking system significantly expands the money supply through its lending activities.