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Answer to Question #46480 in Macroeconomics for Geraldine

Question #46480
1. Suppose you scored a top position in CAPE and you win a scholarship of $100,000 by one of the commercial banks. You deposit the same in the National Commercial Bank. The present required reserve ratio is 13.64%.
a.Explain how the banking system creates money based on deposits?
b.How much money can potentially be created with your deposit of $100,000 under the present required reserve ratio?

2. August is considered as the back-to-school month when parents of school going children spend a lot of money on books and other necessities for their children. Suppose a family withdraws $100,000 from Scotia Bank and spends on their children’s necessities. (The present required reserve ratio is 13.64%)
a.Using the bank’s balance sheet, show the impact on this bank’s assets and liabilities.
b.What is the impact on the bank’s loans?

3.If the banks decide to hold a lower liquidity ratio, what effect will this have on the banks multiplier?
Expert's answer
1. a. Money is a means of exchange and a store of value, or it should be, and in the form of gold and silver it was. Now it is a better means of exchange than ever but it has lost much, if not all, of being a long term store of value. It is created by banks that are members of the bank clearing system, either in the form of loans or by simply allowing cash flows to increase as prices and wages increase. This money exists almost entirely in the form of bank deposits while cash is a small and decreasing proportion of money in circulation. We have reached the point where cash accounts for only £3 out of every £100 we use; £97 has been created by the private banking system.
Money in the form of bank deposits is effectively legal tender because it can be converted into cash by the use of a credit card in a cash machine and as the deposits were originally created by banks acting independently of government they are effectively forged money, counterfeit money, legally forged money.

b. Potentially can be created 100,000/0.1364 = $733137,83 from deposit of $100,000 under the present required reserve ratio.

2. a. Bank’s assets will decrease and liabilities will decrease too by $100,000. But the potential decrease may be much more higher, if we count the ability of creating credit money.

b. The bank now can offer 100,000/0.1364 = $733137,83 less money as loans.

3. If the banks decide to hold a lower liquidity ratio, the banks multiplier will increase.

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