You just deposited $4,000 in cash into a checking account at the local bank. Assume that banks lend out all excess reserves and there are no leaks in the banking system. That is, all money lent by banks gets deposited in the banking system. Round your answers to the nearest dollar. If the reserve requirement is 12%, how much will your deposit increase the total value of checkable bank deposits? If the reserve requirement is 4%, how much will your deposit increase the total value of checkable deposits? Increasing the reserve requirement
The Correct Answer and Explanation is :
To calculate how much your deposit will increase the total value of checkable deposits, we need to use the money multiplier formula: Money Multiplier=1Reserve Requirement\text{Money Multiplier} = \frac{1}{\text{Reserve Requirement}}
Then we multiply the initial deposit by the money multiplier to find the total increase in checkable deposits.
1. Reserve Requirement = 12% (or 0.12)
Money Multiplier=10.12=8.33\text{Money Multiplier} = \frac{1}{0.12} = 8.33 Total Increase in Checkable Deposits=4,000×8.33=33,320\text{Total Increase in Checkable Deposits} = 4,000 \times 8.33 = 33,320
Answer: $33,320
2. Reserve Requirement = 4% (or 0.04)
Money Multiplier=10.04=25\text{Money Multiplier} = \frac{1}{0.04} = 25 Total Increase in Checkable Deposits=4,000×25=100,000\text{Total Increase in Checkable Deposits} = 4,000 \times 25 = 100,000
Answer: $100,000
Explanation (300+ words):
The process of money creation in the banking system is driven by the fractional reserve banking system, where banks are required to hold only a fraction of their deposits as reserves and are allowed to lend out the rest. This reserve fraction is known as the reserve requirement, and it directly influences the money multiplier, which determines the total amount of money that the banking system can generate from an initial deposit.
When you deposit $4,000 in your checking account, your bank keeps a portion of it as reserves (based on the reserve requirement) and lends out the rest. The person or business receiving the loan then deposits the money back into the banking system—either in the same bank or another. This cycle continues, with each new deposit being partially reserved and partially loaned again.
For a 12% reserve requirement, the money multiplier is 8.33. This means each dollar deposited results in about $8.33 in total deposits created through the lending process. Thus, your $4,000 deposit leads to a maximum expansion of $33,320 in total checkable deposits.
On the other hand, with a 4% reserve requirement, the money multiplier is significantly larger—25. Therefore, the same $4,000 deposit could theoretically increase checkable deposits by $100,000. This larger impact is because banks are required to hold less in reserve and can lend out more, promoting greater expansion of the money supply.
Increasing the reserve requirement reduces the money multiplier, thereby decreasing the amount banks can lend. This contractionary measure is often used by central banks to control inflation or limit excessive economic expansion. Conversely, lowering the reserve requirement increases lending potential and stimulates the economy.