Question

Assume that Company XYZ directly deposits its annual profit at one of the commercial

banks in the country as a checkable deposit and that the reserve ratio is 10%. Trace out the effects of a $60 million profit of XYZ on the value of checkable bank deposits. What is the size of the money multiplier?

Please provide a complete detailed answer for this question

Answer 1

In a fractional reserve system, money is created when entities deposit money in bank accounts because the bank will then be able to loan out this money to others.

The reserve ratio is the percentage of the deposit that the bank is required by the Central bank of a country to keep in reserve and not loan out. This percentage is 10% in this scenario.

Money creation will work like this. Company XYZ will deposit the $60 million profit into the bank. The bank will keep 10% of this in reserve which is $6 million and loan out $54 million. The bank still owes XYZ $60 million but has now created an additional $54 million out of it.

This $54 million will be loan to someone else who will deposit it an a bank which will keep 10% and loan out the rest. This process goes on in theory until it reaches a certain amount.

That amount can be calculated by multiplying the initial deposit by the money multiplier.

Money Multiplier = 1 / Reserve ratio

= 1/ 10%

= 10

This means that depositing $60 million will lead to money being created to the tune of;

= 60 * 10

= $600 million