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Unformatted text preview: tal amount of deposits issued to change by the same multiple as the change in reserves. In our hypothetical example, a receipt of $1 of additional reserves by the banking system would ultimately cause deposits to rise by $8.33. Conversely, a $1 reduction in reserves would cause deposits to shrink by $8.33. The Federal Reserve is able to control the total money supply because, although an individual bank can increase or decrease its reserves (for example, by buying them from or selling them to other banks), the total amount of reserves available to the banking system as a whole is determined by the Federal Reserve.
Dynasty School (www.dynastySchool.com) 2-17 REAL ESTATE FINANCE The multiple expansion or contraction of bank deposits in response to a change in the quantity of reserves occurs because banks and other depository institutions have the power to create new deposits and either lend them out to customers or use them to purchase investments such as government securities. If a bank decides that it is profitable to lend to a car dealer, for example, it credits the dealer's checking account at the bank with the amount of the loan. Conversely, when the dealer repays the loan out of his checking account, the bank simply reduces the deposit correspondingly. Deposits, in other words, can be created and destroyed with the stroke of a pen, or perhaps more accurately in today's environment, by the stroke of a computer key. However, there is a limit on this power to create deposits: depository institutions must have reserves prescribed by the law to back any new deposits they create. In other words, a bank has the opportunity to create new deposits – to make new loans and investments only when it receives new reserves to back the new deposits. For example, suppose a bank receives an additional $1,000 in new reserves (through open market operations by the Fed, described below, which are the most important source of new reserves to banks) and the required reserve ratio is 10 percent,...
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