Fractional-reserve Banking and Reserves Loans Loan

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BU204/02
Unit 8
June 14, 2011

Question:
In Westlandia, the public holds 50% of M1 in the form of currency, and the required reserve ratio is 20%. 1. Estimate how much the money supply will increase in response to a new cash deposit of $500 by completing the accompanying table. (Hint: The first row shows that the bank must hold $100 in minimum reserves—20% of the $500 deposit—against this deposit, leaving $400 in excess reserves that can be loaned out. However, since the public wants to hold 50% of the loan in currency, only $400 × 0.5 = $200 of the loan will be deposited in round 2 from the loan granted in round 1.) RoundDepositsRequired reservesExcess reservesLoansLoan proceeds held as currencyLoan proceeds deposited 1$500.00$100.00$400.00$400.00$200.00$200.00

2$200.00$40.00 $160.00 $160.00 $80.00$80.00
3$580.00 $116.00$464.00$464.00 $232.00 $232.00
4$232.00
totals$1512.00 $256.00 $1024.00 $1024.00 $512.00 $512.00

2. How does your answer compare to an economy in which the total amount of the loan is deposited in the banking system and the public doesn’t hold any of the loans in currency? (Hint: Do another table with none of the loan proceeds held in currency.) RoundDepositsRequired reservesExcess reservesLoansLoan proceeds held as currencyLoan proceeds deposited 1$500.00$100.00$400.00$400.00

2$200.00$40.00 $160.00 $160.00
3 $660.00$132.00 $528.00 $528.00

totals $1360.00$272.00 $1088.00 $1088.00

3. What does this imply about the relationship between the public’s desire for holding currency and the money multiplier? It implies that if the public holds on to their money there would be more money in circulation and less in banks reverse and then the multiplier would be less.
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