Consider the following information about a banking system: new currency deposited in the system = $40 billion, legal reserve ratio = 0.20, excess reserves prior to the currency deposit = $0. the $40 billion deposit of currency into checking accounts will create excess reserves of

The bank will create excess reserve of $200 billion

Explanation:

The question measures the size of credit expansion associated with the new currency deposit. the computation below shows how excess reserves can be computed.

Money multiplier              =   1 /Legal Reserve Ratio  = 1/0.2 = 5

Excess Reserve Created = A x (1 /Legal Reserve Ratio)

Where:                          A  = New currency deposit =  $40

       Legal Reserve Ratio = 0.20      

Excess Reserve Created = $40 x (1/0.2)  =  $40 x 5 =  $200 billion                                          

The legal reserve of 5 indicates that for every unit of money reserved by banks, they are able to create 5 units of same.

The money creation capability of the banking system as a whole is depends on the legal reserve ratio. Legal reserve ratio is a fraction of a bank deposit which the law requires them to hold. The bank can only lend the balance after deducting the legal reserve.

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