Beleaguered State Bank (BSB) holds $250 million in deposits and maintains a reserve ratio of 10 percent. Explain what effect BSB’s action will have on other banks.
The correct answer and explanation is:
Correct Answer:
Beleaguered State Bank (BSB) holds $250 million in deposits and maintains a reserve ratio of 10%, which means it keeps $25 million as reserves and can loan out $225 million. By lending out this $225 million, BSB increases the money supply in the banking system. Other banks will receive deposits from borrowers spending these funds, and they too will hold 10% in reserves and lend out the remainder. This process of repeated lending and depositing leads to a multiplied increase in total money supply throughout the banking system.
Explanation (300 words):
When Beleaguered State Bank (BSB) receives $250 million in deposits, it is required by the reserve ratio of 10% to keep $25 million in reserves and can lend out the remaining $225 million. This lending does not just affect BSB but triggers a chain reaction across the entire banking system.
When BSB lends $225 million, the borrowers typically spend this money, and the recipients of that spending deposit the funds into their banks. These other banks then also maintain the 10% reserve ratio. For example, if a bank receives a deposit of $225 million, it must keep $22.5 million as reserves and can lend out $202.5 million. This new loan is again spent and redeposited, creating a new round of deposits and loans.
This process repeats multiple times in the banking system, known as the money multiplier effect. The money multiplier is the reciprocal of the reserve ratio—in this case, 1 / 0.10 = 10. This means that theoretically, the initial deposit of $250 million can support up to $2.5 billion ($250 million × 10) in total money supply after many rounds of lending and depositing.
Other banks benefit because they gain new deposits from the funds loaned by BSB, increasing their capacity to lend further. This expansion of credit fuels economic growth by providing more funds for investment, consumption, and business activities.
In summary, BSB’s decision to maintain a 10% reserve ratio and lend out the rest not only affects its balance sheet but also stimulates the entire banking system through repeated cycles of deposit creation and lending. This ultimately leads to a significant increase in the overall money supply in the economy.