Question

Explain why a single commercial bank can safely lend only an amount equal to its excess reserves but the commercial banking system can lend by a multiple of its excess reserves. What is the monetary multiplier, and how does it relate to the reserve ratio?

Give details and answer the questions fully.

Answer 1

One bank loses reserves to other banks, but the system does not. When a bank issues a loan, it can expect the lender not to leave in his or her account the proceeds of the loan sitting idle.To spend, most people borrow.Therefore, the lending bank can expect checks to be written against the loan and the bank will soon lose reserves to other banks to the full extent of the loan as the checks are presented for payment. In short, if a bank gives loans to the full extent of its excess reserves, it can expect to lose those excess reserves to other banks in the near future.

It can be seen from this why a bank can not lend more comfortably than its excess reserves If it did, it would soon find that its cash reserves were below the statutory reserve requirement. It can be seen from the above why a multiple of its excess reserves can be borrowed comfortably by the commercial banking system. Although one bank is losing other banks ' assets, the process is not. With a legal cash reserve allowance of, say, 20 percent, Bank "B" can legally borrow $80 (80 percent of $100 loaned by Bank "A") as a new deposit. Bank "C" lends 80 percent of that, namely $64, after receiving Bank "B"'s $80 loan as a new deposit. Note that the banking system's initial $100 excess reserves have already resulted in a $244 increase in money supply (= $100 + $80 + $64). The money supply will continue to rise at a decreasing rate (Bank "D" will increase the money supply by $51.20 in loaning this amount) until the total money supply increase is $500.