Calculate-
a) The monetary base.
b) The banks’ reserve ratio.
c) Currency drain as a % of deposits.
Suppose Mr. Y deposits AED 100,000 into a one-year Certificate of Deposit at 5% interest.
The Central Bank sets the reserve ratio for the banks at 10%.
A) Illustrate how the banks create money with the help of given information.
(Show first 5 steps)
B) Calculate the total money creation in the economy with the help of formula.
Introduction
Monetary Base refers to that portion of the reserves that is maintained by banks in the
commercial sector and either held at their respective vaults in the their own banks or deposited
in their own accounts in the Central Bank together with all the money that is circulating in public.
These include the vault cash which means all the money held by the bank physically.
a). Monetary Base = AED 15 Billion + AED 30 Billion = AED 45 Billion.
b).The banks reserve ratio refers to the regulations by Central banks to commercial banks to
maintain at least a fraction of client’s deposits that’s stored in the banks vault or by deposited to
the central bank.
= 2/3 × AED 300 Billion = AED 200 Billion
c). Currency drain is part of the lending process that the client may withdraw at anytime and
also how banks settle their own accounts and how the money or currency ends up in the public
after withdrawal from the banks.. Currency drain as % of the deposits = AED 30 Billion/
AED300Billion × 100 = 10% (Mankiw, 2002)
Macro – Economics 2
Second Task
a) Illustrate how the banks create money with the help of given information.
Banks make money through the multiplier effect. The bank retains a fraction of customers’
deposits known as the reserve ratio and lends the rest as bank loans. In this case its 10%,
After the deposit by Mr. Y, the bank deducts 10% as the statutory requirement and sets aside
90,000. The bank approves Mr. A’s loan of 90,000 which is paid in full. Mr. A pays his
contractor, B all the 90,000 from his account in the bank. The bank sets aside the required the
10% i.e. 9,000 and again sets aside 81,000. B, the hotelier pays for supplies from
D who has an account in the same bank. The bank retains 10% of 81,000 and sets aside
72,900. D orders and pays E for more supplies and deliveries. The bank again deducts the
required 10% and sets aside 65610. F buys a machine from E who is paid through his account
in the bank which retains 10% and lends the rest to G and which amounts to 59,049. (Mankiw,
2002)
b) Calculate the total money creation in the economy with the help of formula.
The total money in the economy = 100,000 + 90,000 + 81,000 + 72900 + 65610 + 59,049 =
468,559
Change in the amount of money = Money multiplier × change in monetary base
Money multiplier (r), the currency drain c, that’s the increment of the currency held in public
that’s outside the bank. Required reserve = r × deposits.
Money multiplier = 1/ (1-(1-r)
Macro – Economics 3
Currency drain = (1-c)
= 1/ (1-(1-10) (1-c)
For the above case there is no currency drain = 1/ (1-(1-10)
The multiplier factor is 10 that’s the total amount that can be created is while retaining the 10%
is 100,000 × 10 = 1000,000. The total money that can be created in the economy is 1,000,000.
References
Mankiw, N. G. (2002) “Chapter 18: Money Supply and Money Demand”, Macroeconomics (5th
Ed.),
Worth, pp. 482–489
