Why are financial institutions required to keep reserves?
ANSWER: Reserves are required to constrain the amount of bank lending (money creation) that can occur. Without required reserves, theoretically banks would have unlimited power to lend and thereby, expand the money supply without any limit. [text: E p. 253; MA p. 253]
Explain what is meant by fractional reserve banking.
ANSWER: Fractional reserve banking is the system that exists in the United States whereby financial institutions are required to keep only a fraction of their customer deposits in reserve. They may lend out or invest the remainder in qualified securities. This system allows banks to "create" money through the loans that they make. [text: E pp. 252-253; MA pp. 252-253]
Answer the next question based on the following consolidated balance sheet for the commercial banking system. Assume the required reserve ratio is 30 percent. All figures are in millions of dollars.
ASSETS
Reserves
$200
Securities
500
Loans
100
Property
500
LIABILITIES
Deposits
$600
Capital Stock
700
(a) What is the amount of excess reserves in this commercial banking system?
(b) What is the maximum amount that the money supply can be expanded?
(c) If the reserve ratio fell to 25 percent, what is now the maximum amount that the money supply can be expanded?
ANSWER:
(a) Required reserves are $600 million x .30 = $180 million. Actual reserves are $200 million, so excess reserves are $20 million.
(b) The monetary multiplier is 1/.3 or 3.33. Maximum expansion of the money supply is $20 million x 3.33, or 66.67 million.
(c) If the reserve ratio was 25%, then excess reserves would be $50 million [$200 million - (.25 x $600 million)]. The monetary multiplier would be 1/.25 or 4, so the maximum expansion of the money supply is $200 million [4 x $50 million]. [text: E pp. 260-263; E pp. 260-263]
Answer the next question based on the following consolidated balance sheet for the commercial banking system. Assume the required reserve ratio is 20 percent. All figures are in billions of dollars.
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(a) What is the amount of excess reserves in this commercial banking system?
(b) What is the maximum amount that the money supply can be expanded?
(c) If the reserve ratio fell to 10 percent, what is now the maximum amount that the money supply can be expanded?
ANSWER:
(a) Required reserves are $200 billion x .20 = $40 billion. Actual reserves are $60 billion, so excess reserves are $20 billion.
(b) The monetary multiplier is 1/.20 or 5. Maximum expansion of the money supply is $20 billion x 5, or $100 billion.
(c) If the reserve ratio was 10%, then excess reserves would be $40 billion [$60 billion - (.10 x $200 billion)]. The monetary multiplier would be 1/.10 or 10, so the maximum expansion of the money supply is $400 billion [10 x $40 billion].
[text: E pp. 260-263; E pp. 260-263]