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18 Banks & the multiple creation of deposits

Chapter Eighteen Banks & the multiple creation of deposits

Self-assessment Questions

18.1 Excess reserve = $80,000 – $200,000 × 0.25 = $30,000

18.2 After Mary’s deposit, the total reserve and total deposit of Bank E are $6,000 and $11,000

The excess reserves of Bank E is

= $6,000 – $11,000 × 0.2 = $3,800

18.3 From the text, we know that after John’s withdrawal, the total reserves and total deposits of
Bank A are $400 and $1,800 respectively.

After Mary’s deposit, Bank A’s total reserves and deposits are increased to $450 and $1,850

With a total deposit of $1,850, Bank A needs to hold $462.5 in required reserves. It is still
short of required reserves by $12.5.

18.4 When there is a foreign money inflow and it is deposited into the domestic banking system,
the maximum increase in deposits will be equal to the maximum increase in money supply.

18.5 No! Excess reserves increase the liquidity of banks and reduce the risk of a bank run.

Multiple Choice Questions

1 C 2 C 3 A 4 D 5 A
6 C 7 C

4 When the banking system lends its excess reserves (which are $1,000), it will start the process of
multiple deposit creation. The maximum increase in deposits is $5,000 (= $1,000 × 5).

6 If banks recall loans, there will be a multiple deposit contraction and money supply will fall.
Hence, point (1) is wrong.

7 When the public withdraws money, the bank’s total deposits and total reserves will drop. As
total deposits drop, the bank needs to hold less required reserves.

Short Questions

8(a)(i) It is a system under which banks have to keep part of its deposits they have received in
required reserves.

8(a)(ii) No. Credit creation is not possible under a 100% reserve system. All deposits received must
be kept as required reserves under such a system. Therefore, banks cannot lend out any
money and there will be no credit creation.

New Introductory Economics 3rd Edition 41 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)
18 Banks & the multiple creation of deposits

9(i) The maximum banking multiplier is (1/0.25) = 4.

9(ii) The actual banking multiplier is smaller than the maximum banking multiplier because

1) banks voluntarily keep some excess reserves.

2) banks cannot loan out their excess reserves, because of a weak demand for bank loans.

3) there is a cash leakage from the banking system to the public.

Structured Essay Question

10(a)(i) Excess reserves = $(40 – 120 × 0.2) billion = $16 billion

10(a)(ii) The maximum increase in deposit

= 16 billion × (1/0.2) = $80 billion

10(a)(iii) The advantage of holding excess reserves to the banks is that they will be more liquid and
therefore the chance of a bank run will be reduced.

The disadvantage of holding excess reserves to the banks is the loss of potential income
from lending them.

10(b)(i) The minimum reserve ratio measures the percentage of deposits that banks have to hold as
required reserves.

10(b)(ii) 1) Banks’ earning power is reduced because they have to keep more of their deposits in
required reserves. This means that they have less excess reserves to lend.

2) The money supply will be reduced because the size of the maximum banking
multiplier is reduced.

10(c) Under a fractional reserve system, an individual bank can only lend its excess reserves.

Yet, for the whole banking system, one bank’s loans will help create deposits for other
banks. The maximum amount of loans created will be a multiple of the initial excess

New Introductory Economics 3rd Edition 42 © Pearson Education Asia Limited 2003
Suggested Solutions (2004 reprint with minor amendments)