Consider the following situation in the Canadian banking system: • An investment dealer withdraws $10 million from its account at Bank XYZ to
Purchase government securities from the Bank of Canada.
• As a result,$10 million has been withdrawn from the Canadian banking system.
• The target reserve ratio for all banks is 10%.
• All commercial banks operate with no excess reserves.
• There is no cash drain.
TABLE 26-5
Refer to Table 26-5.Assume that Bank XYZ has decreased its loans and re-established its target reserve ratio.The second-generation banks in this scenario will

Question

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When the investment dealer withdraws $10 million from its account at Bank XYZ, it reduces the reserves of the bank by $10 million. As the target reserve ratio for all banks is 10%, Bank XYZ needs to increase its reserves by $1 million (10% of $10 million) to meet its reserve requirements. Since all commercial banks operate with no excess reserves, Bank XYZ will have to decrease its loans by $9 million (the difference between the initial withdrawal and the required reserve) to restore its reserves to the required level.
According to the money multiplier formula, the maximum change in the money supply is equal to the initial change in reserves multiplied by the inverse of the reserve requirement. In this case, the initial change in reserves is -$10 million for Bank XYZ, and the reserve requirement is 10%, or 0.1. Therefore, the maximum potential change in the money supply is (-$10 million) x (1/0.1), which equals -$100 million.
Since the second-generation banks hold deposits at Bank XYZ, their reserves are indirectly affected by the initial withdrawal. Therefore, they will also need to adjust their reserves to maintain the required reserve ratio. Assuming they have no excess reserves, they will need to reduce their loans by $8.1 million (0.1 x $81 million) to restore their reserves to the required level. Therefore, the correct answer is B, decrease their loans by $8.1 million.

Consider the Following Situation in the Canadian Banking System: •