Suppose that the bank has the following balance sheet:
Assets Liabilities
Reserves $75,000 Deposits $500,000
Loans $430,000 Net worth $5,000
If the required reserve ratio is 10 percent, what is the maximum the bank can loan out? Suppose the bank makes this loan and the borrower spends the money, which is deposited in a different bank. Show the impact of these transactions on the bank's balance sheet.
What will be an ideal response?
Since the required reserve ratio is 10 percent, required reserves are 0.1 × $500,000 = $50,000. Thus, excess reserves are $75,000 - $50,000 = $25,000. If the bank loans out that amount, the effect on the balance sheet is shown below. Essentially, reserves will be reduced by $25,000 when the money borrowed is spent and deposited in a different bank. Loans will increase by $25,000. Note that the right-hand side of the balance sheet does not change (it increases by the amount of the loan, then decreases by the amount of the loan when the money is spent):
Assets Liabilities
Reserves $75,000
-$25,000
$50,000
Deposits $500,000
Loans $430,000
+$25,000
$455,000 Net worth $5,000
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