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The money supply contraction process

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 20%. Lorenzo, a client of First Main Street Bank, purchases $1,500,000 of Treasury bills in an open market sale undertaken by the Fed. Upon receipt of Lorenzo's check, the Fed subtracts $1,500,000 from First Main Street Banks Federal Reserve account, thereby extinguishing the money.

Because the required reserve ratio is 20%, the $1,500,000 withdrawal DECREASES / INCREASES First Main Street Bank's required reserves by $300,000 / $1,500,000 / $600,000. In order to maintain the required reserve ratio, First Main Street Bank now must DECREASES / INCREASES its reserves by $900,000 / $1,200,000 / $0 / $1,200,000. One possible way to do this is to INCREASES / DECREASES its outstanding loans.

Assume this process continues, with each successive loan being repaid using a checking account and banks using repayments to replenish their reserves without issuing any new loans. Under these assumptions, the initial destruction of $1,500,000 by the Fed results in an overall decrease of $6,000,000 / $750,000 / $300,000 / $7,500,000 in checkable deposits.

DROP DOWN OPTIONS:

Complete the following table to reflect any changes in First Main Street Bank's balance sheet (before the bank makes any new loans) First Main Street Bank's Balance Sheet Assets Liabilities