Economics (McConnell) AP Edition, 19th Edition

Problem:

A simplified balance sheet for the local bank is shown below. The required reserve ratio is 20%. All figures are in thousands.

1. How much is this bank currently required to hold in reserve? How much does the bank currently hold in excess reserves?
2. Suppose the bank lends out the full amount of its excess reserves. Modify the balance sheet to reflect the creation of the loan.
3. By how much has the money supply increased as a result of the loan?
4. Suppose the borrower of the new loan writes a check for the amount of the loan to purchase new equipment for her business. The equipment seller then deposits the check in an out-of-town bank. Show the new balance sheet for this local bank once the check has cleared.
5. Once the check has cleared, does the local bank have any excess reserves?

Answer:

All values are in thousands of dollars.

1. The bank is required to maintain its reserves at a minimum of 20% of deposits. With $5000 in deposits, its require reserves are 0.2 x $5000 = $1000. With current reserves of $1200, the bank has excess reserves of $1200 – $1000 = $200.
2. Loans and checkable deposits both increase by $200.
   
   

   Assets		Liabilities and net worth
   Reserves	$1200	Checkable deposits	$5200
   Securities	750	Stock shares	1000
   Loans	3700
   Property	550

   
   
3. The loan has created $200 in new money in the form of checkable deposits.
4. Both reserves and checkable deposits fall by $200.
   
   

   Assets		Liabilities and net worth
   Reserves	$1000	Checkable deposits	$5000
   Securities	750	Stock shares	1000
   Loans	3700
   Property	550

   
   Comparing this balance sheet to the beginning balance sheet, the effect of the loan has been to transfer the excess $200 from reserves to loans.
5. No. Required reserves on checkable deposits of $5000 are $1000, equal to the bank’s actual reserves.

Problem:

While clearing debris from a house destroyed by Hurricane Katrina, a group of student helpers discovered a shoe box full of $100 bills--$30,000 in all. The students found the displaced homeowner, who promptly deposited the full amount in the local bank. Suppose the reserve requirement is 25%, and the bank was just meeting its reserve requirement prior to the deposit.

1. How much of this new deposit is this bank required to hold in reserve? How much does the deposit create in excess reserves?
2. What is the value of the monetary multiplier?
3. What is the potential increase in the money supply this new deposit can generate?
4. In an attempt to increase the value of its portfolio, suppose this same bank sells $30,000 in securities to its district Federal Reserve Bank. How much excess reserves will this transaction create for the bank? By how much can the money supply potentially increase as a result of this transaction?
5. Repeat parts a. through d. assuming a reserve ratio of 20%.

Answer:

1. The bank is required to keep 25%, or .25 x $30,000 = $7,500. The remainder, $22,500, is excess reserves.
2. With a reserve requirement of 25%, the monetary multiplier is 1/.25 = 4.
3. The money supply can potentially increase by the multiplier times the initial increase in excess reserves, or 4 x $22,500 = $90,000.
4. The sale to the Fed generates $30,000 in excess reserves for the bank. Its deposits have not changed as a result of the transaction, so there is no change in the amount of reserves required. The Fed simply credits the bank’s reserve account for the amount of the sale. With a money multiplier of 4, the potential increase in the money supply is 4 x $30,000 = $120,000.
5. The $30,000 cash deposit would create $6,000 (= 0.2 x $30,000) in required reserves and $24,000 (= $30,000 – $6,000) in excess reserves. The money multiplier would rise to 1/0.2 = 5, and the potential increase in the money supply would be 5 x $24,000 = $120,000. The securities sale would generate $30,000 in excess reserves and potentially create 5 x $30,000 = $150,000 in new money.