Suppose the desired reserve ratio is 0.2 and the Bank of Canada buys $100,000 in government securities from Big Bank.How much money can the chartered banking system create?

Question

Quizplus · Accepted Answer

The bank of Canada's purchase of $100,000 in government securities from Big Bank increases Big Bank's reserves by $100,000. The desired reserve ratio is 0.2 or 20%, hence, Big Bank is required to hold $20,000 of the $100,000 as reserves, and can potentially loan out the remaining $80,000.

Since the banking system uses a fraction of its reserves to create new loans, the actual amount that can be created is:

Loan = (1/required reserve ratio) x excess reserves
Loan = (1/0.2) x $80,000
Loan = $400,000

This means the entire banking system can potentially create $400,000 in new loans following the Bank of Canada's purchase. Adding the $100,000 of reserves created in the initial purchase, the total amount of money the chartered banking system can create is $500,000. Hence, the correct answer is B) $500,000.

Suppose the Desired Reserve Ratio Is 0