Meagan deposits $750 from her piggy bank into her checking account at Regions National Bank. The reserve requirement is 10% and the bank has no excess reserves.

(a) What is the immediate effect on the M1 measure of the money supply of her deposit? Explain why.

(b) What is the amount of money the local bank can lend?

(c) Calculate how much money the entire banking system can create. Show your work.

(d) Give two reasons why money creation may not increase by the amount you identified in (c).

A. $750

B. $675

C. $7,500

D. 1. Leakage of cash

2. Preference for liquid cash.

Explanation:

A. M1 is a measure of money in the narrow sense. It includes the cash currency in M0 and the deposits in checking accounts (sight deposits), which are perfectly liquid, suitable for immediate everyday payments. With Meagan's deposit of $750 into her checking account, the immediate effect will be an increase in M1 by $750.

B. The amount of money local bank can lend given a reserve requirement if 10% and no excess reserve kept by the bank is 90% of $750.

Reserve requirement = 10% of 750 = $75

Balance = 750 - 75 = 675

So $675 is the amount local bank can lend.

C. Creation of money refers to the multiplication of loans and advances. Recall that in B above, we calculated the amount of money local bank can lend given a reserve requirement of 10% and deposit of 750$ to be $675. This $675 is lent to another individual who deposits same into a checking account. With a reserve requirement of 10%, an amount of $607.5 has been created which can be lent out. This process continues until the final deposit becomes too small to create fresh loan. So we derive a formula for finding the amount of money the entire banking system can create.

nM = iD/r

Where:

nM is the amount of money created

iD is the initial deposit = $750

r is the legal reserve ratio = 10%

nM = 750/10% = 7500

The amount of money the entire banking system can create is equal to $7500.

D. In reality, the power of commercial banks to create credit is subject to the some limitations, making it difficult for banks to create money up to $7500. Two of the reasons are : cash leakage and preference for liquid cash. The money creation multiplier used in the calculation above is based on the assumption that the entire loan is deposited into the banks. Due to either cash leakage or preference for liquid cash, the amount deposited into the banking system will ultimately reduce. This will weaken the multiplier and consequently reduce the amount of money created by the entire banking system.

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