Question

"Suppose the Fed requires banks to hold 10 percent of their deposits as reserves. A bank has $20,000 of excess reserves and then sells the Fed a government bond for $9,000. How much does this bank now have to lend out, if it decides to lend the full amount of its excess reserves?

Answer 1

$29,000

Step-by-step explanation:

If the bank already has $20,000 in excess reserves and it sells $9,000 worth of government bonds, then the excess reserves = $29,000

Banks have the ability to create money through lending, and the amount that the money increases is determined by the money multiplier = 1 / required rate of reserves = 1 / 10% = 10. So $29,000 could theoretically increase the money supply by $290,000.

This happens because a bank lends money to a borrower, after that borrower pays something, the new owner of the money will probably deposit the money in a bank (regardless if it is the same or not), and that bank will be able to lend $29,000 - 10% = $26,100 to another client, and that client again will use the money to pay for something else, and the person that receives the money will deposit it in another bank, and that bank will lend $26,100 - 10% = $23,490, and the wheel goes on and on.