Solved: This problem illustrates how banks create credit and can thereby lend out more

Chapter 13, Problem 23

(choose chapter or problem)

This problem illustrates how banks create credit and can thereby lend out more money than has been deposited. Suppose that initially $100 is deposited in a bank. Experience has shown bankers that on average only 8% of the money deposited is withdrawn by the owner at any time. Consequently, bankers feel free to lend out 92% of their deposits. Thus $92 of the original $100 is loaned out to other customers (to start a business, for example). This $92 will become someone elses income and, sooner or later, will be redeposited in the bank. Then 92% of $92, or $92(0.92) = $84.64, is loaned out again and eventually redeposited. Of the $84.64, the bank again loans out 92%, and so on. (a) Find the total amount of money deposited in the bank. (b) The total amount of money deposited divided by the original deposit is called the credit multiplier. Calculate the credit multiplier for this example and explain what this number tells us.