Explain how banks create loans and how this process is impacted by the reserve requirement and excess reserves. Then, create a scenario that demonstrates how banks create money when they issue loans, being sure to include an initial deposit amount, a reserve requirement ratio, an excess reserve amount, and how much money can be created from a single transaction.

Question

What will be an ideal response?

Answer 1

Answers will vary but should demonstrate understanding of how banks create money through the issuance of loans and how the amount banks have to loan is limited by the reserve requirement and the bank’s excess reserves. For example, a bank might receive an initial deposit of $50,000. If it has a reserve requirement ratio of 10 percent, the bank must keep $5,000 in its reserves, leaving the bank with $45,000 in excess reserves. If the bank loans those excess reserves to a single borrower and that borrower deposits the money in a new bank account, the transaction has created $45,000 in checkable deposits.