Answer:
The bank will create excess reserve of $200 billion
Explanation:
The question measures the size of credit expansion associated with the new currency deposit. the computation below shows how excess reserves can be computed.
Money multiplier = 1 /Legal Reserve Ratio = 1/0.2 = 5
Excess Reserve Created = A x (1 /Legal Reserve Ratio)
Where: A = New currency deposit = $40
Legal Reserve Ratio = 0.20
Excess Reserve Created = $40 x (1/0.2) = $40 x 5 = $200 billion
The legal reserve of 5 indicates that for every unit of money reserved by banks, they are able to create 5 units of same.
The money creation capability of the banking system as a whole is depends on the legal reserve ratio. Legal reserve ratio is a fraction of a bank deposit which the law requires them to hold. The bank can only lend the balance after deducting the legal reserve.
