Money and Banking-2.pptVIP

Required Reserve Ratio The reserve requirement is represented by the required reserve ratio (r). This ratio is the percent of deposits the bank must hold. If r is 20% and deposits are $1,000,000: The bank must hold (.2)(1,000,000) = $200,000 in reserve. Excess Reserves Banks may choose to hold more than is required. Any reserves over the requirement are called excess reserves. Reserves = Required reserves + excess reserves In the previous example: Bank A has $1,000,000 in deposits. The required reserve ratio is 20%. Required reserves are 0.2 * 1,000,000 = $200,000. Banks hold $500,000 in reserve. $500,000 = $200,000 {Required reserves} + $300,000 {Excess reserves} Multiplier Effect Open market operations (and other monetary policy changes) have a multiplier effect in the economy. Any increase in reserves can be immediately lent out, thus increasing the money supply. Due to fractional reserve banking, the same dollar can be lent out multiple times. $100,000 increase in the reserves. 10% reserve requirement Bank A Change in Reserves Change in Lending $100,000 $90,000 The loan is deposited in: Bank B Change in Reserves Change in Lending $90,000 $81,000 The loan is deposited in: Bank C Change in Reserves Change in Lending $81,000 $72,900 The loan is deposited in: Bank D Change in Reserves Change in Lending $72,900 $65,610 The loan is deposited in: Bank E Change in Reserves Change in Lending $65,610 $59,049 Change in money supply is 90,000 + 81,000 + 72,900 + 65,610 + 59,049 = $368,559. It would actually be larger, since this can be carried further. Simple Deposit Multipliers The money multiplier is a means of measuring this multiplier effect. The money multiplier (m) = 1/(required reserve ratio) The required reserve ratio will be a decimal. This assumes that banks do not wish to hold excess reserves, and that all money stays in the financial system. (No money leaks out.) Example The multiplier effect can be calculated by: Change in reserves * simple deposit mult