Question

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?

EXPLANATION PLEASE

Answer 1

Solution:

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

Thus, excess reserve = 2-0.6 = $1.4 million.

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

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

c) All of the excess reserves may not be advanced as loan because the bank may have to perform regular activities such as same day settlements and urgent requirements.

d) If new reserve ratio is 50% then excess reserve will be 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 is advanced as loan then new reserve requirement i.e extra $0.4 million may be met by selling government securities or borrowing from the market.