Question

After saving money in her piggy bank for three years, Beverly decided to deposit $5,000 of the money in the Millertown Bank. If the bank were fully loaned out and the reserve requirement was 20%, the amount the bank can create is:
It's supposed to be 20,000.....but HOw????

Answer 1

$20,000 is correct

When they ask for the amount the bank can "create" they are really asking for the change in the money supply. They are required to reserve 20%, so they can loan out 80%

80% * $5,000= $4,000

Now, the bank can use this $4,000 by loaning it out to other customers and earning interest on those loans. The customers can use the money for investments or spending. So the first little deposit of $5,000 has now spread to a lot more people and created a lot more opportunity for growth. This is known as the multiplier effect. To put the multiplier effect in dollar amounts, we need to know how much we are multiplying by. This is called the deposit multiplyer and the formula is 1/(required reserve ratio). The reserve ratio here is 20% or .2

1/(.2)= 5

Our deposit multiplier which will calculate the multiplier effect on the money supply (aka the amount the bank can "create") is 5

5* $4,000= $20,000