Final answer:
The question deals with the concept of reserve requirements and the role they play in the banking system. A given scenario with a 25% reserve ratio and $1,700,000 in deposits indicates that a bank must hold $425,000 in reserves. This scenario allows for a potential increase in the money supply up to $6,800,000 through the money multiplier effect.
Step-by-step explanation:
Understanding Reserve Requirements and Money Multiplication
The question focuses on the concept of reserve requirements set by the Federal Reserve for banks and the money creation process through bank lending. Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. The student is given a scenario with a 25% required reserve ratio, $1,700,000 in checkable deposits, suggesting a situation where there are no excess reserves and no cash leakage.
As of March 2020, due to the pandemic-induced recession, the Federal Reserve reduced reserve requirements to 0%. Despite this change, understanding the mechanics of reserve requirements is critical in grasping how monetary policy and bank regulation work. Under the previous system, if a bank had checkable deposits of $1,700,000 and a reserve ratio of 25%, it would be required to hold $425,000 in reserves.
This reserve ratio effectively limits the amount that banks can lend, as they must keep a fraction of deposits as reserves. With the reserve ratio applied, banks can create loans up to the amount of their excess reserves, which leads to an expansion of the money supply through the money multiplier effect.
The money multiplier is determined by the reserve ratio and is calculated as the inverse of that ratio. In this case, with a 25% reserve ratio, the multiplier would be 1 divided by 0.25, which equals 4. Therefore, the initial $1,700,000 can potentially support a total of $6,800,000 in checkable deposits throughout the banking system after multiple rounds of bank lending and depositing.