Chapter 35
The two conflicting goals facing commercial banks are: deposits and withdrawals. profit and loss. assets and liabilities. profit and liquidity.
profit and liquidity. Explanation Profit and liquidity: The two conflicting goals facing commercial banks are profit and liquidity. On the one hand, commercial banks want to make profits. On the other hand, they need liquidity so that at least some of the assets that they own can be quickly liquefied and sold for cash if an unexpectedly large number of depositors suddenly want their money back. This causes a conflict for bank managers because assets and investments that offer higher rates of return are typically not very liquid. Thus, banks must compromise between earning higher profits and remaining suitably liquid in their asset holdings.
A commercial bank has $100 million in checkable-deposit liabilities and $12 million in actual reserves. The required reserve ratio is 10 percent. How big are the bank's excess reserves? $88 million $2 million $100 million $12 million
$2 million Explanation $2 million: This bank has $2 million of excess reserves. The bank's excess reserves can be calculated by subtracting the bank's required reserves from the bank's actual reserves of $12 million. The bank's required reserves are $10 million (= 0.10 (reserve ratio of 10 percent) × $100 million in checkable-deposit liabilities). Thus, the bank's excess reserves are equal to $2 million (= $12 million in actual reserves - $10 million in required reserves).
Third National Bank has reserves of $20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent. Households deposit $5,000 in currency into the bank and that currency is added to reserves. Instructions: Enter your answer as a whole number. What level of excess reserves does the bank now have?
$4,000 Explanation The first step is to calculate checkable deposits. This equals the original checkable deposits plus the new deposit, or $105,000 (= $100,000 + $5,000). The second step is to calculate required reserves for the deposits. This equals the product of the required reserve ratio (decimal form) and checkable deposits. Required reserves = 0.20 × $105,000 = $21,000. The third step is to calculate excess reserves. This equals actual reserves minus required reserves. Since the $5,000 deposit was added to the original reserves of $20,000, the new (actual) reserves equal $25,000. Excess reserves = actual reserves - required reserves = $25,000 - $21,000 = $4,000. Play Video
Suppose that Third National Bank has reserves of $20,000 and checkable deposits of $100,000. The reserve ratio is 20 percent. The bank sells $5,000 in securities to the Federal Reserve Bank in its district, receiving a $5,000 increase in reserves in return. Instructions: Enter your answer as a whole number. What level of excess reserves does the bank now have?
$5,000 Explanation The $5,000 sale of securities is directly transferred into the reserves of the bank. This increases reserves by $5,000 to $25,000, but since this was a sale of securities there is no change in checkable deposits immediately following the transaction. The fact that checkable deposits have not changed implies that required reserves have not changed, so required reserves still equal $20,000. Thus, excess reserves equal $5,000 (= actual reserves - required reserves = $25,000 - $20,000).
Suppose that Serendipity Bank has excess reserves of $8,000 and checkable deposits of $150,000. Instructions: Enter your answer as a whole number. If the reserve ratio is 20 percent, what is the size of the bank's actual reserves?
38000 Explanation The first step is to calculate the required reserves for the bank. This equals the product of the required reserve ratio (decimal form) and checkable deposits. Required reserves = 0.20 × $150,000 = $30,000. The second step is to calculate actual reserves. This is the sum of required reserves and excess reserves. Actual reserves = required reserves + excess reserves = $30,000 + $8,000 = $38,000. Play Video
Consider the following statement: "When a commercial bank makes loans, it creates money; when loans are repaid, money is destroyed." This statement is incorrect, because lending decreases the money supply and the repayment reduces checkable deposits, which raises the money supply. correct, because lending decreases the money supply and the repayment reduces checkable deposits, which raises the money supply. incorrect, because lending increases the money supply while the repayment reduces checkable deposits, which lowers the money supply. correct, because lending increases the money supply while the repayment reduces checkable deposits, which lowers the money supply.
correct, because lending increases the money supply while the repayment reduces checkable deposits, which lowers the money supply. Explanation Banks add to checking account balances when they make loans; these checkable deposits are part of the money supply. People pay off loans by writing checks; checkable deposits fall, meaning the money supply drops. Thus, money is "destroyed."
A single commercial bank in a multibank banking system can lend only an amount equal to its initial preloan _________________. total reserves excess reserves total deposits excess deposits
excess reserves Explanation Excess reserves: A single commercial bank in a multibank banking system can lend only an amount equal to its initial preloan excess reserves. This is true because when a bank makes a loan, it faces the possibility that checks for the entire amount of the loan will be drawn and cleared against it. So, to be safe, the bank will limit its lending to the amount of its excess reserves. That way, after that amount is lent out, the bank will have sufficient total reserves to meet the reserve requirements for all of its loans, including the newly issued loans.
A decrease in the reserve requirement causes the size of the monetary multiplier toincrease, the amount of excess reserves in the banking system to increase, and the money supply to increase.decrease, the amount of excess reserves in the banking system to increase, and the money supply to increase.decrease, the amount of excess reserves in the banking system to increase, and the money supply to decrease.increase, the amount of excess reserves in the banking system to increase, and the money supply to decrease.
increase, the amount of excess reserves in the banking system to increase, and the money supply to increase. Explanation The monetary multiplier is k = 1/(1− required reserve ratio). Thus, a decrease in the required reserve ratio will result in an increase in the multiplier because each bank will need to hold less reserves and therefore can make more loans. This also implies that the bank will see an increase in excess reserves after the fall in the required reserve ratio. The ability to make more loans results in an increase in the potential money creation through the fractional reserve banking system.
The actual reason that banks must hold required reserves is: to enhance liquidity and deter bank runs. to help increase the number of bank loans. to help fund the Federal Deposit Insurance Corporation, which insures bank deposits. to give the Fed control over the lending ability of commercial banks.
to give the Fed control over the lending ability of commercial banks. Explanation By varying the required reserve ratio, the Fed can increase or decrease the total volume of lending made by commercial banks. For example, a higher required reserve ratio means that banks must hold more of their total deposits as reserves. And because any money that is held as reserves cannot be lent out, raising the required reserve ratio also means reducing the amount of money that banks can loan out. Keep in mind that the true point of required reserves is to give the Fed this control over lending. By contrast, it is a common fallacy to think that the point of reserves is to provide banks with a ready supply of funds to meet unexpectedly large cash withdrawals from depositors (as happens during bank panics). This line of thinking is not true because the legally required amount of reserves is not nearly large enough to deal with bank panics, which is why the government has also created the FDIC and NCUA to provide deposit insurance and why the Fed always stands ready to act as a lender of last resort to any banks suffering from bank panics. The deposit insurance and the availability of the Fed as a lender of last resort protect the banking system against bank panics while required reserves give the Fed control over lending.
Suppose that the Fed has set the reserve ratio at 10 percent and that banks collectively have $2 billion in excess reserves. What is the maximum amount of new checkable-deposit money that can be created by the banking system? $20 billion $0 $200 million $2 billion
$20 billion Explanation $20 billion: The correct answer is that the banking system can create a maximum of $20 billion in new checkable-deposit money. To see why this is true, begin with the fact that the monetary multiplier m is the reciprocal of the reserve ratio. That is, m = (1/R). Given that the Fed in this problem has set the reserve ratio at 10 percent, this formula implies that the monetary multiplier will be equal to 10 (= 1/0.10). Next, remember that the banking system's maximum checkable-deposit money creation D is equal to the banking system's excess reserves E times the monetary multiplier, or D = E × m. Given that we know that the excess reserves are $2 billion and m = 10, this formula implies that the maximum checkable-deposit money creation will be D = $20 billion (= $2 billion in excess reserves × monetary multiplier of 10). The initial $2 billion in excess reserves can be multiplied into up to $20 billion in new checkable-deposit money because when bank A extends a loan and creates new money, that money will eventually be deposited in another bank B, where any part of that amount except the required reserve amount can be lent out again. With this process repeating itself from bank B to bank C to bank D, a single dollar in initial excess reserves at bank A can initiate a much larger total volume of loans.
Suppose that the banking system in Canada has a required reserve ratio of 10 percent while the banking system in the United States has a required reserve ratio of 20 percent. In which country would $100 of initial excess reserves be able to cause a larger total amount of money creation? Canada United States
Canada Explanation Canada: A single dollar of initial excess reserves will be able to cause a larger total amount of money creation in Canada. This is true because Canada has a lower required reserve ratio. As a result, more money can be created by banks through the process of multiple-deposit expansion. The money multiplier equals 1/required reserve ratio. The money multiplier in Canada equals 1/0.1 = 10. The money multiplier in the United States equals 1/0.2 = 5. Thus, the $100 of initial excess reserves will lead to money creation of $100 × 10 = $1,000 in Canada but only $100 × 5 = $500 in the United States.
Suppose that last year $30 billion in new loans were extended by banks while $50 billion in old loans were paid off by borrowers. What happened to the money supply? Stayed the same Decreased Increased
Decreased Explanation Decreased: We know this to be true because last year the total dollar amount of loans decreased by $20 billion (= $30 billion in new loans extended - $50 billion in old loans paid off). That will have caused a $20 billion decline in checkable deposits and an even larger decline in the money supply as banks lose excess reserves and the monetary multiplier works in reverse.
Consider the following statement: "Whenever currency is deposited in a commercial bank, cash goes out of circulation and, as a result, the supply of money is reduced." Is this statement true or false?True, because the deposit in a commercial bank decreases M1.True, because the M1 money supply consists of currency outside of the banks and checking account deposits of the public in the commercial banks.False, because a checkable deposit in a commercial bank is also part of the money supply.False, because the deposit in a commercial bank reduces cash which reduces M1.
False, because a checkable deposit in a commercial bank is also part of the money supply. Explanation False: The M1 money supply consists of currency outside of the banks (cash in the hands of the public) and checking account deposits of the public in the commercial banks. The deposit of currency in a checking account in a bank has changed the form of the money supply but not the amount.
Answer the following questions: Instructions: Enter your answers as whole numbers. a. If the required reserve ratio is 10 percent, what is the monetary multiplier? b. If the monetary multiplier is 4, what is the required reserve ratio?
a. 10 b. 25% Explanation a. The monetary multiplier equals 1 divided by the required reserve ratio. Monetary multiplier = 1/required reserve ratio = 1/0.1 = 10. b. We can rearrange this question to solve for the required reserve ratio when given the monetary multiplier. Required reserve ratio = 1/monetary multiplier = 1/4 = 0.25, or 25 percent. This is the last question in the assignment. To submit, use Alt + S. To access other questions, proceed to the question map button.
a. The banking system in the United States is referred to as a fractional reserve bank system becausea fraction of the money is lent out.banks keep a fraction of reserves available.banks hold a fraction of deposits in reserve.a fraction of all monetary assets are held in banks.b. In a fractional reserve system, deposit insuranceraises the fraction of deposits that banks must keep available.provides additional funds that can be lent out.is absolutely necessary or the banking system would collapse.guarantees that depositors will always get their money, avoiding bank runs.
a. banks hold a fraction of deposits in reserve. b. guarantees that depositors will always get their money, avoiding bank runs. Explanation a. The banking system in the United States is a fractional reserve bank system because the banks do not hold enough cash or reserves on hand to pay every depositor on demand at the same time. That is, if everyone went to the bank at the same time and tried to close their accounts, the bank would not be able to meet this demand.b. To avoid the potential of these bank runs, there is deposit insurance in the United States and other countries. By guaranteeing depositors that they will always get their money, deposit insurance removes the incentive to try to withdraw one's deposit before anyone else can. It thus stops most bank runs.
a. Suppose that Mountain Star Bank discovers that its reserves will temporarily fall slightly below those legally required. It can temporarily remedy this situation byborrowing funds from other banks in the federal funds market.suspending operations until reserves increase.borrowing funds from large firms in the federal funds market.lowering its deposit levels.b. Now assume Mountain Star Bank finds that its reserves will be substantially and permanently deficient. To remedy this situation, Mountain Star Bank cansuspend operations.borrow funds from large firms in the federal funds market.buy securities to permanently increase its reserves.reduce the amount of loans outstanding.
a. borrowing funds from other banks in the federal funds market. b. reduce the amount of loans outstanding. Explanation a. If Mountain Star Bank discovers that its reserves will temporarily fall slightly below those legally required, it can borrow reserves in the federal funds market to cover its shortfall. It will borrow from banks that have excess reserves in the short term. b. If Mountain Star finds that its reserves will be substantially and permanently deficient, it will need to reduce the amount of loans outstanding or sell securities to permanently increase its reserves.
a. A single commercial bank can safely lend only an amount equal to its excess reserves, but the commercial banking system as a whole can lend by a multiple of its excess reserves because one bank loses reserves to other banks, but the banking system as a whole does not. this is the legal restriction on banks, but it does not apply to the banking system as a whole. the banking system as a whole has more funds than any single commercial bank. one bank gains reserves, but the banking system as a whole loses these reserves. b. What is the monetary multiplier? 1 + reserve ratio 1/reserve ratio 1 - reserve ratio Reserve ratio - 1 c. The monetary multiplier is inversely related to the reserve ratio. directly related to the reserve ratio. one minus the reserve ratio. one plus the required reserve ratio.
a. one bank loses reserves to other banks, but the banking system as a whole does not. b. 1/reserve ratio c. inversely related to the reserve ratio. Explanation a. When a bank grants a loan, it can expect that the borrower will not leave the proceeds of the loan sitting idle in his or her account. Most people borrow to spend. Therefore, the lending bank can expect that checks will be written against the loan and that the bank will shortly lose reserves to other banks, as the checks are presented for payment to the full extent of the loan. In short, when a bank grants loans to the full extent of its excess reserves, it can shortly expect to lose these excess reserves to other banks. From this, it can be seen why a bank cannot safely lend more than its excess reserves. If it did, it would soon find that its cash reserves were below its legal reserve requirement. b. The monetary multiplier (m) is defined as the reciprocal of the required reserve ratio or 1/R where R is the required reserve ratio. It is a separate idea from the spending multiplier but shares some mathematical similarities (The spending income multiplier is the reciprocal of the MPS or the leakage that occurs at each round of spending.). c. The monetary multiplier is inversely related to the reserve ratio.
a. An asset on a bank's balance sheet is something owed by the bank, whereas a liability is something owned by the bank. sold by the bank, whereas a liability is something bought by the bank. created by the bank, whereas a liability is something sold by the bank. owned by the bank, whereas a liability is something owed by the bank. b. Net worth is equal to (Assets + liabilities)/assets. Assets + liabilities. Assets - liabilities. Liabilities - assets. c. A balance sheet must always balance because the sum of assets must equal the difference of liabilities minus net worth. liabilities must equal the sum of assets plus net worth. assets must equal the sum of liabilities plus net worth. net worth must equal the sum of liabilities plus assets. d. The major assets on a commercial bank's balance sheet include checkable deposits, securities, loans, and vault cash. reserves, checkable deposits, loans, and vault cash. reserves, securities, loans, and vault cash. reserves, securities, loans, and checkable deposits. e. The major claim on a commercial bank's balance sheet is reserves. loans. vault cash. checkable deposits.
a. owned by the bank, whereas a liability is something owed by the bank. b. Assets - liabilities. c. assets must equal the sum of liabilities plus net worth. d. reserves, securities, loans, and vault cash e. checkable deposits. Explanation a. An asset of a commercial bank is something owned by the bank or owed to the bank (cash, securities, loans, etc.). A liability of the bank is a claim against the bank by nonowners (checkable deposits, etc.) and the owners of the bank. b. Net worth is equal to assets minus liabilities. c. A balance sheet is a statement of assets and claims (or liabilities and net worth). It must balance because every asset is claimed by someone, so that assets (the left-hand side) = liabilities + net worth (the right-hand side). d. The major assets of a bank are reserves, securities, loans, and vault cash (this last one is relatively small when compared to the others). e. The major claim on the bank is checkable deposits.
a. The Federal Reserve requires commercial banks to have reserves because reserves provide the Fed a means of controlling the money supply. this is the way the Fed monitors bank solvency. reserves are a claim that commercial banks have against the Federal Reserve Banks. reserves are needed for banks to earn money. b. Reserves are an asset to commercial banks but a liability to the Federal Reserve Banks because in the determination of net worth, these must be equal. these funds are cash belonging to commercial banks, but they are a claim that commercial banks have against the Federal Reserve Banks. commercial banks and the Federal Reserve Banks do not use the same accounting system. these funds are cash belonging to the Federal Reserve Banks, but they are a claim that the Federal Reserve Banks have against commercial banks. c. Excess reserves are equal to Required reserves - actual reserves. Actual reserves + required reserves. Actual reserves - required reserves. Required reserves + actual reserves. d. Excess reserves can be lent out, which increases the money supply. can be lent out, which decreases the money supply. must be borrowed, which increases the money supply. must be borrowed, which decreases the money supply.
a. reserves provide the Fed a means of controlling the money supply. b. these funds are cash belonging to commercial banks, but they are a claim that commercial banks have against the Federal Reserve Banks. c. Actual reserves - required reserves. d. can be lent out, which increases the money supply. Explanation a. Reserves provide the Fed a means of controlling the money supply. It is through increasing and decreasing excess reserves that the Fed is able to achieve a money supply of the size it thinks best for the economy. b. Reserves are assets of commercial banks because these funds are cash belonging to them; they are a claim the commercial banks have against the Federal Reserve Banks. Reserves deposited at the Fed are a liability to the Fed because they are funds it owes; they are claims that commercial banks have against it. c. Excess reserves are the amount by which actual reserves exceed required reserves: Excess reserves = actual reserves - required reserves. d. Commercial banks can safely lend excess reserves, thereby increasing the money supply.
a. Merchants accepted gold receipts as a means of payment even though the receipts were issued by goldsmiths, not the government, because the government's currency could not be trusted. goldsmiths issued a receipt to the depositor. they knew that the gold receipts could be exchanged for gold. gold receipts were the only type of payment offered. b. By issuing loans in the form of gold receipts, there was additional risk because goldsmiths could issue more receipts than they had in gold and this could create a panic. gold could be stolen. receipts could be copied. the government could demand all the gold.
a. they knew that the gold receipts could be exchanged for gold. b. goldsmiths could issue more receipts than they had in gold and this could create a panic. Explanation a. When early traders began to use gold in making transactions, they soon realized that it was both unsafe and inconvenient to carry gold and to have it weighed and assayed (judged for purity) every time they negotiated a transaction. So by the sixteenth century they had begun to deposit their gold with goldsmiths, who would store it in vaults for a fee. On receiving a gold deposit, the goldsmith would issue a receipt to the depositor. Soon people were paying for goods with goldsmiths' receipts, which served as one of the first types of paper money. Merchants were willing to accept this receipt because they knew that it could be exchanged for gold or reused to purchase goods and services for the merchant. b. The potential problem was that if the goldsmith issued more receipts than he had in gold the goldsmith was vulnerable to "panics" or "runs." For example, if a goldsmith issued paper money equal to twice the value of his gold reserves he would be unable to convert all that paper money into gold in the event that all the holders of that money appeared at his door at the same time demanding their gold.
