.Shock 1: Suppose that Uncle Tom finds $1 Million in paper money under his mattress and deposits it in a bank. Initial SituationAfter DepositingStep 1:Banking System Banking System Assets LiabilitiesAssets LiabilitiesLoans $8 Million| Deposits $10 Million Loans $8 Million| Deposits $11 MillionG-Bonds $2 Million|G-Bonds $2 Million|Reserves $1Million| Net Worth $1 MillionReserves $2Million| NW $1 MillionTotal Assets $11 M| Total Liabilities $11TAssets $12 M|TLiabilities $12 MStep 1: The Bank (the Banking System as a whole) receives the deposit and puts the money in its reserves (vault cash). Soon it realizes that it has excess reserves over and beyond what is legally required. For deposits of $11M, the bank needs to keep only $11M*0.10=$1.1M as required reserves. So, the bank finds itself with excess reserves of $2M-$1.1M=$0.9M. The story gets really interesting in terms of its effect on the money supply if the bank decides to loan this excess reserve rather than keeping it as excess reserves or investing it in G-bonds.Route One: Bank keeps this excess reserve as G-bonds.Route Two: Bank make new loans.Banking System Banking System Assets LiabilitiesAssets LiabilitiesLoans $8 M| Deposits $11 Million Loans $8 Million| Deposits $11 MillionG-Bonds $2.9 M|G-Bonds $2 Million|Reserves $1.1M| Net Worth $1 MillionReserves $2Million| NW $1 MillionTotal Assets $12 M| Total Liabilities $12TAssets $12 M|TLiabilities $12 MStop here if Route One was taken: Ms=CC+DepositsInitially=$1M(assume that was the total CC under the mattress)+$10M.=$11MNow:=$0+$11M=$11M (No Change in Money Supply if Banks invest the excess reserves generated by new deposits on g-bonds)Route Two: If banks loan out the excess reserves in the amount of $0.9M=new loans, then if these loan proceeds find their way back to the banking system as deposits, then the second round of deposit and money creation takes place. This...
