Question

The following table depicts the consolidated balance sheet of all banks in an economy’s banking system.  Each bank has fixed target reserve ratio of 10 percent.  There is no currency drain, and banks do not hold excess reserves. Figures are in millions of dollars.

All Banks
Reserves          $3,000	Deposits         $30,000
Loans             $26,000 Securities        $1,000

(a)        What is the amount of excess reserves initially?  (5 points)

(b)        Now the Bank of Canada purchases 60 million of securities in an open market operation from the banking system.  Show how this transaction affects the banking system’s balance sheet. (15 points)

(c)        What is the level of excess reserves in the banking system now?  (5 points)

(d)        Given the situation in section (c) and if the banks respond by increasing loans, what will be the maximum increase in loans?   Draw up a new balance sheet that reflects the banks’ position after loans have been extended by its maximum amount and excess reserves are equal to zero. (15 points)

Answer 1

(a)

Deposits = $30,000

Reserve ratio = 10% or 0.10

Required reserves = Deposits * Reserve ratio = $30,000 * 0.10 = $3,000

Total reserves = $3,000

Calculate the amount of excess reserves -

Amount of excess reserves = Total reserves - Required reserves = $3,000 - $3,000 = $0

Thus,

The amount of excess reserves initially is $0.

(b)

It has been stated that Bank of Canada has purchased 60 million of securities in an open market operation from the banking system.

This will result in an increase in reserves of the banking system by $60 million and decrease in securities of the banking system by $60 million.

Following is the required balance sheet -

Reserves	$3,060	Deposits	$30,000
Loans	$26,000
Securities	$940

(c)

Initially, the banking system has zero excess reserves.

Now, they have got additonal reserves of $60 million.

This all are excess reserves of the banking system.

Thus,

The level of excess reserves in the banking system now is $60 million.

(d)

Calculate the increase in loans -

Increase in loans = Excess reserves * [1/Reserve ratio]

Increase in loans = $60 million * [1/0.10] = $60 million * 10 = $600 million

Thus,

The maximum increase in loans would be $600 million.

Following is the required balance sheet reflecting the banks' position after loans have been extended by its maximum amount and excess reserves are equa to zero -

Reserves	$3,060	Deposits	$30,600
Loans	$26,600
Securities	$940