CREATION OF BANK MONEY (DEMAND DEPOSITS)
Suppose the Federal Reserve System pours $1000 of new money into the banking system by buying government securities. What will be the total amount of bank money, or demand deposits, that will be generated ultimately?
Following the fractional reserve system, if we assume that the law requires banks to keep a 20 percent reserve backing for the deposits they create, then by the well-known multiplier process the total amount of demand deposits that will be generated will be equal to $1000[1/(1 - 0.8)] = $5000. Of course, $5000 in demand deposits will not be created overnight. The process takes time, which can be shown schematically in Figure 17.3.
Initial 1 2 3 4 5 6 7 Final
$1000 Stages in expansion
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