Econ Chapter 15
A commericial 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?
$2 millionFeedback: 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 (= reserve ratio of 10 percent (0.10) × $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).
Suppose that the fed has set the reserve ratio to 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 billionFeedback: 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.
P: Suppose that Serendipity Bank has excess reserves of $8,000 and checkable deposits of $150,000. If the reserve ratio is 20 percent, how much does the bank hold in actual reserves?
$38,000. Feedback: The first step is to calculate the required reserves for the bank, which equals the product of the required reserve ratio (decimal from) and checkable deposits. Required reserves = 0.20 x $150,000 = $30,000. The second step is to calculate actual reserves, which is the sum of required reserves and excess reserves. Actual Reserves = Required Reserves + Excess Reserves = $30,000 + $8,000 = $38,000
P: 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 the bank adds that currency to its reserves. What amount of excess reserves does the bank now have?
$4,000. Feedback: The first step is to calculate checkable deposits. This equals the original checkable deposits plus the new deposit, $105,000 (= $100,000 + $5,000). The second step is to calculate required reserves for the deposits, which equals the product of the required reserve ratio (decimal from) and checkable deposits. Required Reserves = 0.20 x $105,000 = $21,000. The third step is to calculate excess reserves, which 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
P: Suppose the assets of the silver lode bank are $100,000 higher than on the previous day and its net worth is up $20,000. By how much and in what direction must its liabilities have changed from the day before?
$80,000 increase. Feedback: By definition (balance sheet approach) the total amount of assets must equal liabilities plus net worth. Assets = liabilities + Net worth. We can extend this logic to changes. That is, the change in assets must equal the change in liabilities plus the change in net worth.Δ Assets = Δ liabilities + Δ Net worth. Substituting the values above, we have:$100,000 = Δ liabilities + $20,000 This implies that Δ liabilities = $80,000, which is obviously an increase in liabilities.
D: What is the difference between an asset and a liability on a bank's balance sheet? How does net worth relate to each? Why must a balance sheet always balance? What are the major assets and claims on a commercial bank's balance sheet?
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 non-owners (checkable deposits, etc...) and the owners of the bank. This last liability is the net worth of the bank. The balance sheet must balance by definition. That is, the sum of assets must equal the sum of liabilities plus net worth for the bank to ensure appropriate accounting of transactions. The major assets of a bank are reserves, securities, loans, and vault cash (this last one is relatively small when compared to the others). The major claim on the bank is checkable deposits.
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 resreve ratio of 20 percent. In which country would $100 of iniitial excess reserves be able to cause a larger total amount of money creation?
Canada Feedback: 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. For instance, suppose we are looking at Canada and that the initial $100 of excess reserves starts with Canada Bank A. Given the Canadian required reserve ratio of 10 percent, Canada Bank A could legally lend out $90 of the initial $100, holding the other $10 back for reserves. Suppose that Canada Bank A does indeed make $90 in loans, which later get deposited into Canada Bank B. Then Canada Bank B will be able to lend out $81, holding the other $9 back in reserves in order to meet the 10 percent required reserve ratio. Compare those first two rounds of lending in Canada with the similar first two rounds that would take place in the United States with its higher reserve ratio of 20 percent. To make things concrete, suppose that the initial $100 of excess reserves starts with U.S. Bank A. U.S. Bank A could then legally lend out only $80 of the $100, because the required reserve ratio of 20 percent would mean that it would have to hold the other $20 back for reserves. Suppose that U.S. Bank A does indeed make $80 in loans, which later get 3deposited into U.S. Bank B. Then U.S. Bank B will be able to lend out $64, because it would have to hold back $16 (= 0.20 × $80) in required reserves. Thus the first two rounds of lending in Canada result in $90 and then $81 of new loans and money creation while the first two rounds in the United States result in only $80 and then $64 of new loans and money creation. Subsequent rounds will also have Canada exceeding the United States in the amount of loans extended and checkable-deposit money created. Thus, the higher reserve ratio in the United States reduces the overall level of money creation relative to what is possible in Canada because at each round of lending U.S. banks have to hold back more money as reserves.
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?
Decreased Feedback: 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.
A single commercial bank in a multibank banking system can lend only an amount equal to its intitial preloan ______________.
Excess reserves. Feedback: 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.
Why does the federal reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by a bank? What is the significance of excess reserves?
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. 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 Bank. 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.
Whenever currency is deposited in a commercial bank, cash goes out a circulation and, as a result, the supply of money is reduced. Do you agree? Explain why or why not.
Students should not agree. 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 into a checking account in a bank has changed the form of the money supply but not the amount.
D: Why is the banking system in the United States referred to as a fractional reserve banking system? What is the role of deposit insurance in a fractional reserve system?
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. 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.
Does leverage increase the total size of the gain or loss from investment, or just the percentage rate of return on the part of the investment amount that was not borrowed? How would lowering leverage make the financial system more stable?
The monetary multiplier is k = 1/(1- required reserve ratio). (a) Thus, a decrease in 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. (b) This also implies that the bank will see an increase in excess reserves after the fall in the required reserve ratio. (c) 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:
c. To give the Fed control over the lending ability of commercial banks. Feedback: 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.
