Answer to Question #324318 in Macroeconomics for alli

Question

1.      Imagine that the banking system received additional deposits of $100 million and that all the individual banks wish to retain their current liquidity ratio of 20%.

a.      How much of the$100 Million will banks choose to lend out initially? (2mks)

b.      What will happen to banks liabilities when the money that is lent out is spent and the recipients of it deposit it in their bank accounts? (2mks)

c.      How much of these latest deposits will be lent out by the banks? (2mks)

d.      By how much will total deposits eventually have risen, assuming that none of the additional liquidity is held outside the banking sector? (2mks)

e.      How much of these extra total deposits are matched by (i) liquid assets; (ii) illiquid assets? (2mks)

f.       What is the size of the bank multiplier? (3ms)

g. If one-half of any additional liquidity is held outside the banking sector, by how much less will deposits have risen compared with (d) above? (5mks)

Answer 1

a. Since the liquidity ratio (or reserve ratio) is 20%, the banks will lend 1-20% or 80% initially, i.e., $80M

b. When the money lent out initially is spent and the recipients deposit it in their bank accounts, the banks' liabilities go up by $80M

c. Similar to a. above, 80% of these new deposits will also be lent, i.e., $64M

d. Eventually (i.e., after many such cycles as described in a. to c. above) the deposits would have risen by $500M (including the original $100M). This is a result of money multiplier which is calculated as 1/r, where r is the reserve ratio. So what will happen is that the banking system will have $500M as deposits (on liabilities side), $100M as cash (or reserves), and $400M as loans, both of which will be on the assets side. We can also see that reserves are equal to 20% of deposits

e. Cash, which is a liquid asset, backs these deposits for $100M, and loans, which are illiquid for another $400M

f. The size of the bank multiplier is 5.

g. If one-half of any additional liquidity is held outside the banking sector, that means $50 million is held in the banking sector.

That additional liquidity would create

$=50\times5$

$= $250$ Million.

h.So total deposits risen = Amount in banking sector + Outside the banking sector

$= 250 + 50$

= $300 Million

This is $200 Million less than the deposits that would have risen compared with (d) above

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