Question

1) You are the president of the First National Bank of Frederick. Currently, you have $2 million in seed (start-up) deposits. The Fed requires that banks hold 30% of deposits in reserve. Given this information:a) What are your excess reserves?b) What is the MAXIMUM about of money that would be created if all excess reserves were loaned to customers. (Hint: think Money multiplier)c) What might prevent the bank from lending out ALL of its excess reserves?d) What if the Fed determined that the new reserve ratio should be 50%. What impact would this have on your maximum calculated in b)? --If all of your prior reserves were out in the form of loans, what options would you have to meet your reserve requirements?

Answer 1

Solution:

a) The amount in reserve = 30% of $2 million = $0.6 million

Hence excess reserve = 2-0.6 = $1.4 million.

b) Money multiplier = 1/reserve ratio = 1/0.3 = 3.33

Hence, maximum money creation = money multiplier*total deposit = 3.33*2 = $6.66 million

c) All of the excess reserves may not be lent out because the bank may have to perform day to day activities such as intra-day settlements.

d) If new reserve ratio is 50% then excess reserve will be only 2-1 = $1 million

Total money creation will be 2*2 = $4 million. Here money multiplier = 1/0.5 = 2

If prior reserves i.e $1.4 million were out in the form of loan then new reserve requirement i.e extra $0.4 million may be met by selling government securities or borrowing from the market.