The reserve ratio is 20 percent. A check for $1 million is deposited in Bank A, written on an account from Bank B. After the check clears what are the new excess reserves at Bank A, and by how much does the money supply change if all banks make loans so that they have zero excess reserves?

Question

Quizplus · Accepted Answer

When a $1 million check is deposited in Bank A, Bank A gains $1 million in reserves. However, they must keep 20% in reserve, so they can only lend out $800,000. Therefore, the new excess reserves at Bank A are $800,000.

If all banks make loans to have zero excess reserves, then Bank A would lend out their entire $800,000. When the borrower receives the $800,000, they will deposit it in their bank, where that bank must hold 20% in reserve ($160,000) and can lend out the remaining $640,000. This process will repeat with each bank until the total increase in the money supply is $4 million [($800,000+$640,000+$512,000+...)= $4 million]. Therefore, the money supply would increase by $4 million - the initial $1 million = $3 million.

The Reserve Ratio Is 20 Percent