Suppose the Federal Reserve purchases $10,000 of Treasury bonds from you and that you deposit the $10,000 into your checking account deposit at Bank Y. Assume that Bank Y has no excess reserves at the time you make your deposit and that the required
reserve ratio is 20 percent.
a. Use a T-account to show the initial effect of this transaction on Bank Y's balance sheet.
b. Suppose that Bank Y makes the maximum loan they can from the funds you deposited. Use a T-account to show the initial effect on Bank Y's balance sheet from granting the loan. Also include in this T-account the transaction from question (a.).
c. Now suppose that whoever took out the loan in question (b) writes a check for this amount and that the person receiving the check deposits it in Bank Z. Show the effect of these transactions on the balance sheet of Bank Y and Bank Z, after the check has been cleared. On the T-account for Bank Y, include the transactions from questions (a) and (b).
d. What is the maximum increase in checking account deposits that can result from your $10,000 deposit? What is the maximum increase in the money supply? Explain.
What will be an ideal response?
a. Bank Y's checking account deposits and reserves rise by $10,000.
Bank Y
Assets Liabilities
Reserves +$10,000 Deposits + $10,000
b. Bank Y has to hold $2,000 of required reserves, leaving $8,000 of excess reserves which they loan. Bank Y increases the checking account of the borrower by $8,000.
Bank Y
Assets Liabilities
Reserves +$10,000 Deposits + $10,000
Loans +$8,000 Deposits +$8,000
c. At Bank Y, when the $8,000 check clears, reserves will fall by $8,000 and the borrower's checking account will be empty. At Bank Z, the deposit of the $8,000 check increases checking account deposits and reserves by $8,000.
Bank Y
Assets Liabilities
Reserves +$2,000 Deposits + $10,000
Loans +$8,000
Bank Z
Assets Liabilities
Reserves +$8,000 Deposits + $8,000
d. The maximum increase in checking account deposits is $50,000: $10,000 times the simple deposit multiplier of , or 5. The money supply also increases by $50,000, because the original deposit of $10,000 came from a check from the Federal Reserve.
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