Fractional Reserve BankingSuppose that the Federal

Chapter 11, Problem 41

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Fractional Reserve BankingSuppose that the Federal Re-serve (the Fed) buys $100 million of government debtobligations from private owners. This creates $100 mil-lion of new money and sets off a chain reaction because ofthe fractional reserve banking system. When the $100million is deposited into private bank accounts, the bankskeep only 15% in reserve and may loan out the remaining85%, creating more new money: (.85)(100) million dollars.The companies that borrow this money turn around andspend it, and the recipients deposit the money in their bank accounts. Assuming that all the (.85)(100) millionis redeposited, the banks may again loan out 85% of thisamount, creating (.85)2(100) million additional dollars.This process may be repeated indefinitely. Compute thetotal amount of new money that can be created theoreti-cally by this process, beyond the original $100 million. (Inpractice, only about an additional $300 million is created,usually within a few weeks of the action of the Fed.)

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