Question

People hold $200 million of bank deposits but no currency. Banks have made $180 million dollars of loans and only
hold enough reserves to satisfy reserve requirements. Because of uncertainty, banks choose to hold $10 million more in
reserves, meaning that they now have $10 million in excess reserves plus their required reserves. The Fed takes no
action. What happens to bank loans?
a. they fall by $200 million
b. they fall by $100 million
c. they rise by $100 million
d. they rise by $200 million

Answer is B, but why? What concepts need to be understood in order to arrive at this answer?

Answer 1

Initially,

Total assets = Deposits = Total reserves + Loans

$200 million = Total reserves + $180 million

Total reserves = $20 million

Since banks hold total reserves that is the required reserves (= Deposits x Required reserve ratio),

Required reserves = $20 million = $200 million x Required reserve ratio

Required reserve ratio = $20 million / $200 million = 0.1

Next,

Banks keep $10 million as excess reserves, instead of lending this amount. So credit lending falls by an initial amount of $10 million. Since excess reserves are used as loans, $10 million initial increase in excess reserve will lead to $10 million initial decrease in loans. After all the rounds of lending-deposit process in entire banking system is done,

Total decrease in loans = Initial decrease in loans / Required reserve ratio = $10 million / 0.1 = $100 million