2 Assume the reserve requirement of an economys banking syst

2. Assume the reserve requirement of an economy\'s banking system is 10% and all banks extend loans until excess reserves equal zero. Initially, total reserves of the banking sector equal S5,000 and currency held outside of banks equals $1,000. Assume all of the $1,000 in cash belongs to Paul. a) What is the total dollar amount of demand deposits in this economy? b) What is the size of M1? Now suppose Paul decides to use his cash to open up a demand deposit (checking account) at Ren\'s Bank and Trust. (You may assume that all other individuals do not hold any currency, but put all of their money in banks.) o What is the total dollar amount of new demand deposits that the banking sector will create as a result of Paul\'s action? d) What is the new size of M1?

Solution

(a) For a bank\'s balance sheet, Total assets (Reserves) = Total deposits (liabilities plus equity)

Total deposits = $5,000

(b) M1 = Currency (cash) with public + Deposits

M1 = $1,000 + $5,000 = $6,000

(c) Money multiplier (MM) = 1/Required reserve ratio = 1/0.1 = 10

Total new deposit creation = Increase in deposits x MM = $1,000 x 10 = $10,000

(d) New M1 = Initial value of M1 + Total new deposit creation

New M1 = $6,000 + $10,000 = $16,000