Assets Liabilities

Reserves Demand Deposits

Required reserves

Excess reserves

Govt. securities

Plainsville Bank

Assume a young lady goes into Plainsville Bank and deposits $100 cash into her checking. The reserve
ratio is 20% and the bank has no excess reserves. How much can the bank lend (fill out the balance
sheet above)?

What is the change in demand deposits? (Hint: This question only had 14% of test takers answer
correctly because it is misleading. The change in demand deposits is multiplied by the reserve
requirement multiplier because this $100 cash deposit has a domino effect on other banks.)

What is the change in the money supply?

Assume the Federal Reserve buys $5 million in government bonds in the open market. What is the
maximum increase in money supply from this open market operation?

Given this increase in money, what will happen to real wages?

Answer key

The bank can lend $80

The maximum change in demand deposits is $100 times 5, so $500

Change in money supply was $400

The Fed increases money supply by $25 million

Real wages will fall because of inflation