Money Supply Process: If A Bank Depositor Withdraws $1,000

Money Supply Process 1. If a bank depositor withdraws $1,000 of currency from an account, what happens to reserves, checkable deposits, and the monetary base?

The withdrawal of $1,000 of currency from a bank deposit impacts several components of the banking system and the monetary base. When a depositor withdraws cash, the bank's reserves decrease by the amount of currency withdrawn because reserves include both the bank's cash holdings and deposits at the Federal Reserve. Specifically, the reserves held at the Federal Reserve decrease by $1,000, and the bank's checkable deposits—liabilities reflecting the amount owed to depositors—also decrease by the same amount because the withdrawal reduces bank liabilities. Consequently, the monetary base, which comprises currency in circulation and reserves, decreases by $1,000 as currency in circulation increases by that amount while reserves decrease correspondingly, or vice versa depending on who holds the cash. Essentially, this transaction reduces the bank's reserves and checkable deposits, and it causes a decline in the monetary base unless the currency released is held outside the banking system as currency in circulation.

2. You find a $100 note and deposit it in your bank account. How will this affect the money supply?

Depositing a found $100 banknote into your bank account increases the checkable deposits by $100, which directly raises the money supply. This is because the deposit is now part of the money available for transactions, and as such, expands the overall monetary aggregates. The currency in circulation decreases by $100 since the cash is now held within the banking system as a deposit. Since the deposit becomes part of the bank’s liabilities, checkable deposits increase by $100, and reserves rise proportionally, depending on the reserve ratio enforced by the Federal Reserve. Overall, this deposit boosts the money supply by the amount of the deposit, assuming it is deposited into a commercial bank, and the banking system may subsequently create more money through the lending process depending on reserve requirements.

3. The Fed buys $300 million of bonds from the public and also lowers the required reserve ratio. What will happen to the money supply? Why?

The Federal Reserve’s purchase of $300 million in bonds from the public injects liquidity into the banking system, increasing reserves. This open-market operation raises banks' reserves, enabling them to lend more money, which expands checkable deposits and consequently increases the money supply. Simultaneously, lowering the required reserve ratio means banks are required to hold less reserves relative to their deposits, further amplifying the potential for deposit-based money creation. The combination of increased reserves and reduced reserve requirements leads to a multiplier effect, significantly expanding the overall money supply. This monetary policy tool aims to stimulate economic activity by making more funds available for loans and investments within the economy.

4. Describe how each of the following can affect the money supply: (a) the central bank; (b) banks; and (c) depositors.

(a) The central bank influences the money supply primarily through open-market operations, discount rate adjustments, and reserve requirements. When the central bank buys bonds in open-market operations, it increases reserves and expands the money supply, whereas selling bonds contracts it. Lowering reserve requirements allows banks to hold less reserves and lend more, increasing money creation, while raising them has the opposite effect. Changing the discount rate impacts banks’ borrowing costs from the Federal Reserve, influencing their willingness to lend.

(b) Banks affect the money supply through their lending activities. When banks expand lending, they create new checkable deposits, thereby increasing the money supply. Conversely, when banks tighten lending standards or reduce their loans, the growth of the money supply slows or contracts.

(c) Depositors influence the money supply via their deposit and withdrawal behaviors. Increased deposits, for example, through savings or cash injections, expand the banking system’s reserves and potential for money creation. Conversely, withdrawals reduce reserves and can lead to a contraction of money supply if banks limit lending or face reserve shortages.

5. When the Fed sells $4 million of bonds to Eagle Bank what happens to reserves and the monetary base? Use T-accounts to explain your answer.

Banking System Assets Liabilities

  • Reserves decrease by $4 million
  • Cash holdings decrease by $4 million

Federal Reserve Assets Liabilities

  • Assets: Bonds decrease by $4 million
  • Liabilities: Reserves decrease by $4 million

In this transaction, Eagle Bank’s reserves decrease by $4 million as it pays for the bonds, reducing the banking system’s reserves. The Federal Reserve’s holdings of bonds decline correspondingly by $4 million, and the reserves at the Fed decrease by the same amount, leading to a contraction of the monetary base by $4 million.

6. The Fed sells $2 million of bonds to an investor, who pays with currency. What happens to reserves and the monetary base? Use T-accounts to explain your answer.

Banking System Assets Liabilities

  • Reserves decrease by $2 million

Investor Assets Liabilities

  • Assets: Bond decreases by $2 million
  • Liabilities: Currency account increases by $2 million (cash payment)

Federal Reserve Assets Liabilities

  • Assets: Bonds decrease by $2 million
  • Liabilities: Reserves decrease by $2 million

This transaction reduces the banking system reserves by $2 million as the investor pays in currency. The Fed’s holdings of bonds decrease by $2 million, and the reserves at the Fed decrease accordingly. The monetary base contracts by $2 million because both the Fed’s reserves and the currency in circulation decline.

7. If the Fed lends banks a total of $100 million. What happens to reserves and the monetary base? Use T-accounts to explain your answer.

Banking System Assets Liabilities

  • Reserves increase by $100 million

Federal Reserve Assets Liabilities

  • Assets: Loan (or discount loans) increase by $100 million
  • Liabilities: Reserves increase by $100 million

Lending to banks increases their reserves by $100 million, which in turn raises the monetary base by the same amount. This expansion provides banks with additional capacity to increase lending, thereby potentially increasing the money supply through the money multiplier process.

8. From question 7, the public withdraws $50 million in deposits to hold as currency. What happens to the banking system, Fed and Public? Use T-accounts.

Banking System Assets Liabilities

  • Reserves decrease by $50 million
  • Checkable deposits decrease by $50 million

Federal Reserve Assets Liabilities

  • Reserves decrease by $50 million

Public Assets Liabilities

  • Currency in circulation increases by $50 million

The public’s withdrawal of $50 million in deposits results in a reserve decline in banks by the same amount, and checkable deposits decrease accordingly. The Federal Reserve’s reserves also decrease by $50 million, reflecting the cash withdrawn, while the currency in circulation increases by this amount. This transfer reduces the banking system’s reserves and checkable deposits but raises currency outside banks.

9. Suppose that currency in circulation is $100 billion, the amount of checkable deposits is $900 billion, and excess reserves are $180 billion and the required reserve ratio is 10%. Calculate the money supply, monetary base, the currency deposit ratio, the excess reserve ratio, and the money multiplier

Given data:

- Currency in circulation (C) = $100 billion

- Checkable deposits (D) = $900 billion

- Excess reserves (ER) = $180 billion

- Reserve ratio (rr) = 10% or 0.10

Money supply (M)

M = C + D = $100 billion + $900 billion = $1,000 billion or $1 trillion

Monetary base (H)

H = Reserves (R) + Currency in circulation (C). Reserves include required reserves and excess reserves. Since excess reserves are $180 billion and the reserve ratio is 10%, total reserves are R = 0.10 × $900 billion = $90 billion, but the excess reserves are $180 billion, indicating total reserves are actually $180 billion (excess reserves) plus required reserves; so total reserves are R = $180 billion + R_required.

Required reserves R_required = 0.10 × $900 billion = $90 billion

Therefore, total reserves R = $180 billion (excess) + $90 billion (required) = $270 billion

Thus, the monetary base H = R + C = $270 billion + $100 billion = $370 billion

Currency deposit ratio (C/D)

C/D = $100 billion / $900 billion ≈ 0.111 or 11.1%

Excess reserve ratio (ER/R)

ER / R = $180 billion / $270 billion ≈ 0.667 or 66.7%

Money multiplier (m)

m = (C/D + 1) / (C/D + ER/R + R/D)

Note: R/D = R / D = $270 billion / $900 billion = 0.3

m = (0.111 + 1) / (0.111 + 0.667 + 0.3) ≈ 1.111 / 1.078 ≈ 1.031

Alternatively, the standard formula: m = (C + D) / (C + R), but given the ratios, the approximate money multiplier is just over 1, showing a very low level of deposit expansion due to high excess reserves.

10. Suppose depositors lose confidence in the banking system and withdraw $800 billion. How will values found in question 1 change?

Withdrawal of $800 billion drastically reduces checkable deposits and reserves. Checkable deposits decrease by $800 billion, reserves decrease accordingly, and the monetary base shrinks significantly. Reserves held at banks drop, leading to contraction of the money supply. The overall effect is a sharp decline in money creation capacity, potentially causing a slowdown in the economy or a financial crisis. The monetary base reduces by $800 billion, and checkable deposits also decrease by the same amount, severely constraining the banking system's ability to create new deposits.

11. Suppose depositors regain confidence and deposit $800 billion but now excess reserves increase to $360 billion. How will values found in question 1 change?

If depositors deposit $800 billion, checkable deposits increase correspondingly. However, with excess reserves now at $360 billion, banks hold more reserves than before, which can limit lending and reduce the money multiplier effect. The total reserves increase, but the high excess reserves indicate banks are not fully utilizing their reserve capacity to expand the money supply. The money supply increases through deposits but at a diminished multiplier effect due to excess reserves, leading to a more cautious expansion of deposits.

12. Find the money multiplier when currency in circulation is $600 billion, checkable deposits are $900 billion, excess reserves are $15 billion and the required reserve ratio is 10%. How will reduction in the required reserve ratio to 5% affect the money multiplier?

Given data:

- C = $600 billion

- D = $900 billion

- ER = $15 billion

- rr = 10% or 0.10

Calculate total reserves R:

R_required = rr × D = 0.10 × $900 billion = $90 billion

Total reserves R = ER + R_required = $15 billion + $90 billion = $105 billion

Calculate initial money multiplier (m):

m = (C/D + 1) / (C/D + ER/R + R/D)

When reserve ratio reduces to 5%:

R_required_new = 0.05 × $900 billion = $45 billion

New total reserves R_new = ER + R_required_new = $15 billion + $45 billion = $60 billion

The lower reserve ratio increases the potential for deposit creation, raising the money multiplier from a lower value to a higher one, increasing the expansion capacity of the banking system, thus making money more plentiful in the economy and stimulating economic activity.

References

  • Fabozzi, F. J. (2021). Foundations of Fixed Income Analysis. John Wiley & Sons.
  • Mishkin, F. S. (2019). The Economics of Money, Banking, and Financial Markets (12th ed.). Pearson.
  • Blanchard, O. (2017). Macroeconomics (7th ed.). Pearson.
  • Federal Reserve Bank of St. Louis. (2020). Understanding the Monetary Policy Process. Retrieved from https://www.stlouisfed.org
  • Mankiw, N. G. (2020). Principles of Economics (9th ed.). Cengage Learning.
  • Cecchetti, S. G., & Schoenholtz, K. L. (2014). Money, Banking, and Financial Markets (4th ed.). McGraw-Hill Education.
  • Board of Governors of the Federal Reserve System. (2020). Monetary Policy Report. https://www.federalreserve.gov
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  • Taylor, J. B. (2019). Monetary Policy Rules. University of Chicago Press.
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