The following question refer to the table that follows. Assume that there is a fractional-reserve banking system, that the legal reserve requirements are 10 percent, and that the balance sheet for Bank X is as follows:

-If Bank X safely increases its loans
A) the country's money supply is unaffected.
B) the bank's net worth is immediately increased.
C) both its demand deposit liabilities and its assets will be temporarily increased by the amount of the loan.
D) only its demand deposit liabilities will be increased.
E) its demand deposit liabilities will be increased by some multiple of the loan.

Question

The following question refer to the table that follows. Assume that there is a fractional-reserve banking system, that the legal reserve requirements are 10 percent, and that the balance sheet for Bank X is as follows:
 
-If Bank X safely increases its loans
A) the country's money supply is unaffected. 
B) the bank's net worth is immediately increased. 
C) both its demand deposit liabilities and its assets will be temporarily increased by the amount of the loan. 
D) only its demand deposit liabilities will be increased. 
E) its demand deposit liabilities will be increased by some multiple of the loan.

Quizplus · Accepted Answer

When Bank X safely increases its loans, both its demand deposit liabilities and its assets will be temporarily increased by the amount of the loan. This is because when Bank X makes a loan, it credits the borrower's demand deposit account with the loan amount. However, the bank also creates a new asset in the form of the loan itself. Since Bank X has a legal reserve requirement of 10 percent, it must hold a fraction of the new deposit as reserves and can lend out the remainder. Therefore, the money supply in the country will also increase temporarily. However, as the loan is repaid, the demand deposit liabilities and the money supply will decrease. Note that net worth is not immediately affected by an increase in loans, as the loan is also an asset for the bank.

The Following Question Refer to the Table That Follows