Question

The Federal Reserve specifies a percentage of checkable deposits that banks hold must hold as reserves (required reserves), which is called the required reserve ratio. Excess reserves are reserves that banks hold over and above the required reserves and can make loans. Suppose that Bank A has an increase in checkable deposits of $100 million and the required reserve is 10%. How much money can Bank A create by making loans? How much money can the banking system as a whole create? Show your detailed calculation. What can you say about the relationship between the required reserve ratio and money creation? Why do some banks hold a part in excess reserves instead of loaning all excess reserves out? What are some other ways that banks may use a portion of their excess reserves?

Answer 1

Bank A can make loans deposit(1-rr) 100(1-0.1) 100(0.9) $90 million Money banking system can create deposit/required reserves 100/0.1 $1000 million Money creation - deposit/required reserve ratio Banks hold a part in excess reserves in the form of required reserves instead of loaning out all money in order to keep some part of their deposits as buffer or back p security amount which can be used in the times of emergency. If banks loan out all money and it all goes bankrupt, then the bank will have nothing for itself and will immediately go bankrupt too Banks can keep a portion of excess reserves in gold deposits or loan out to government, which are safer yet return-full investments.