Commercial banks create credit by lending out a proportion of the deposits they receive while keeping a fraction in reserve. If the reserve ratio is 10% and...
Question 1 Report
Commercial banks create credit by lending out a proportion of the deposits they receive while keeping a fraction in reserve. If the reserve ratio is 10% and an initial deposit of $1,000 is made, the maximum total deposits the banking system can create is
Answer Details
The correct answer is $10,000.
The credit multiplier determines the maximum total deposits the banking system can create from an initial deposit. It is calculated as:
\[ \text{Credit multiplier} = \frac{1}{\text{Reserve ratio}} = \frac{1}{0.10} = 10 \]
Maximum total deposits = Initial deposit \(\times\) Credit multiplier = $1,000 \(\times\) 10 = $10,000.
This $10,000 figure represents the total deposits in the banking system, including the original $1,000. The process works because the bank lends out $900 (keeping $100 in reserve), which is deposited elsewhere and re-lent, and so on until the total reaches $10,000. The figure of $9,000 would represent only the new loans created, not the total deposits. $1,000 is only the initial deposit, and $100,000 would require a 1% reserve ratio.
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