1. Money creation is facilitated by commercial banks. The process of money creation happens through the creation of deposits. The method of deposit creation means that the higher the deposits created by any commercial banks, then the result in the economy is more supply of money. On the other hand, the reserve ratio is the reserve liabilities’ portion determined through the central banks and is a part of the creation of the deposits. Additionally, the reserve ratio minimizes the ability of money creation by banks. The higher the reserve ratio, the lower the money supply in the economy.
The simple deposit multiplier = 1 / rate = 1 / 8%
= 1 / 0.08
= 12.5
The causes of lower deposit multiplier would be because of a decrease in the interest rates that cause the commercial banks not ready to offer all the available excess reserves. Hence, reduces the multiplier and the general money supply.
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2. Deposit is $10,000
Bank A’s reserves immediately increase by $10,000
Bank A’s required reserve increase by 20% x $10,000 = 0.02 x $10,000 = $2,000
Bank A’s excess reserve increase by ($10,000 - $2,000) = $8,000
Bank A can make a maximum new loan of $8,000 – forms the component of excess reserve.
Checking account deposits in the banking system as a whole (including the original deposit) could eventually increase up to a maximum of: (Deposit / Required reserve ratio) = $10,000 / 20% = $10,000 / 0.2 = $50,000
3. A bank run occurs when a greater number of bank depositors at once withdraw their money from the bank’s deposit reserves - as a result of solvency concerns (Diamond, Douglas & Philip, p 401). The simultaneous withdrawal causes a severe liquidity crisis and gradual bank fall.
According to fractional reserve banking, a given fraction of all the depositors is backed by cash. The case means that only a portion withdraws and not all depositors withdrawing one. Therefore, a bank run occurs when a more significant proportion of depositors demand withdrawal since the bank has a fraction of cash deposits ready for withdrawal.
The innovation in place today is “Federal Deposit Insurance Corporation” formed in 1933 to insure banks, hence confidence is gained by depositors.
4. Monetary policy tools
Open market operations – Fed sells or buys the government securities to either reduce or increase the money supply.
Required reserves ratio – Fed increases or reduces RRR to increase or reduce money supply while making use of either contractionary or expansionary monetary policy.
Discount rate – Fed would check on the discount rate to know the charges of short-term loans. It is either raised or reduced while implementing expansionary policies.
The diagram on: Fig1 discount rate
Work Cited
Diamond, Douglas W., and Philip H. Dybvig. "Bank runs, deposit insurance, and liquidity." Journal of political economy 91.3 (1983): 401-419.
McLeay, Michael, Amar Radia, and Ryland Thomas. "Money creation in the modern economy." (2014).
