How Deposits Are Created: First Generation Banks

Let consider what happens When new reserves are injected into the banking system. Assume that the Federal Reserve buys a ,1000 government bond from Ms. Bond holder, and She deposits the $1000 in her checking account at Bank 1.

But Bank 1 now has $900 more in reserves than It.needs to meet the reserve requirement. Because .’reserves earn no interest, our profit-minded bank will lend or invest the excess $900. The loan might be for a car, or the investment might be a purchase of a Treasury bond. Let’s say the bank makes a loan. The person who borrows the money takes the $900 (in Cash or check) and deposits it in her account in another bank. Very quickly, then, the $900 will be paid out by Bank 1.

But if we calculate the.amount of money. we are in for a big surprise. In addition to the original $1000 of deposits shown on the right of’Table 25-5 (b) , there is $900 of demand deposits in another account (i.e., in the checking account of the person who got the $9(0). Hence, the total amount of M is now $1900. Banal I’s activity has $900 of new.

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