If reserves in the banking system increase by 1 billion because the Fed lends 1 billion to fin

If reserves in the banking system increase by 1 billion...

Key Concepts

Money Multiplier

The money multiplier is a concept that explains how an initial injection of reserves into the banking system can lead to a much larger increase in the overall money supply, particularly checkable deposits. It shows that banks only need to hold a fraction of their deposits as reserves, thereby allowing the remainder to be lent out, which then becomes deposits in other banks and so on. This process continues until the system reaches an equilibrium where the total reserves in the banking system are the fraction required by the reserve requirement ratio multiplied by the total deposits.

Reserve Requirements

Reserve requirements refer to the percentage of deposits that banks are legally required to hold as reserves rather than lend out. They are a critical regulatory tool that ensures banks have enough liquidity to meet withdrawal demands. In an equilibrium state, the amount of reserves held by banks is exactly what is needed to support the level of checkable deposits, based on the reserve requirement. When there is a discrepancy — such as having too few reserves relative to checkable deposits — the system is not in balance, and banks must adjust either by acquiring additional reserves or reducing their deposit liabilities.

Banking System Equilibrium

Banking system equilibrium is reached when banks hold the exact amount of reserves mandated by regulation relative to their deposits, meaning the system’s asset structure is stable and consistent with reserve requirements. If deposits increase by an amount that is not matched by the necessary reserve increase, the system is out of equilibrium. Banks must then seek to correct this by either obtaining additional reserves from the interbank market or adjusting lending practices until the ratio of reserves to deposits aligns with regulatory standards.

T-account Representation in Equilibrium

A T-account for the banking system is used to illustrate the balance between assets and liabilities, showing how reserves (an asset) support checkable deposits (a liability). In equilibrium, the T-account would reflect that the increase in deposits is fully backed by the increase in reserves, maintaining the required reserve ratio. This representation helps visualize the process through which banks adjust their balance sheets, ensuring that the levels of assets and liabilities are appropriately matched as required by monetary policy.

Transcript

00:01 So here within the money supply process, we're going to be using the multiple deposit creation formula and concept in order to determine the equilibrium point for the banking system as a whole.

00:11 And we're determining this in a situation which we're told that the fed has lent $1 billion to banks.

00:19 And as a result, reserves have increased by $1 billion.

00:23 Checkable deposits, however, have only increased by $9 billion.

00:26 And we're also given that the required reserve ratio is 10%.

00:30 So in order to determine this equilibrium point and why we're currently not in equilibrium, i'll tell you that to start that we are not there right now with the checkable deposits being only $9 billion.

00:39 What we first need to do is figure out what this change in deposits should have been.

00:43 Right here, so this is what this multiple deposit creation formula is giving us.

00:47 We know that our change in reserves is $1 billion.

00:50 So let's start to fill in this formula so we can find our change in deposits, what it should have been at least.

00:55 So our change in reserves is that $1 billion.

00:57 We were told that it increased by.

01:01 And then we're going to multiply that by one divided by this reserve ratio, which we were told us 10%.

01:07 So that's 0 .1.

01:10 Now if we multiply that out, we'll see that our change in deposits should have been equal to $10 billion.

01:17 So we can see that as of right now, we are $1 billion away from that...

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