Key Question

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32 2 (Key Question) 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.

Excess reserves are the amount by which actual reserves exceed required reserves: Excess reserves: Excess reserves = actual reserves - required reserves. Commercial banks can safely lend excess reserves, thereby increasing the money supply.

32 4 (Key Question) “When a commercial bank makes loans, it creates money; when loans are repaid, money is destroyed.” Explain.

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. Money is “destroyed.”

32 8 (Key Question) Suppose that Continental Bank has the simplified balance sheet shown below and that the reserve ratio is 20 percent:


(1) (2)

Liabilities and net worth

(1) (2)







Checkable deposits $100,000



a. What is the maximum amount of new loans that this bank can make? Show in column 1 how the bank’s balance sheet will appear after the bank has lent this additional amount.

b. By how much has the supply of money changed? Explain.

c. How will the bank’s balance sheet appear after checks drawn for the entire amount of the new loans have been cleared against this bank? Show this new balance sheet in column 2.

d. Answer questions a, b, and c on the assumption that the reserve ratio is 15 percent.

(a) $2,000. Column 1 of Assets (top to bottom): $22,000; $38,000; $42,000. Column 1 of Liabilities: $102,000.

(b) $2,000. The bank has lent out its excess reserves, creating $2,000 of new demand-deposit money.

(c) Column 2 of Assets (top to bottom): $20,000; $38,000; $42,000. Column 2 of Liabilities; $100,000.

(d) (a) $7,000. Column 1 of Assets (top to bottom): $22,000; $38,000; $47,000. Column 1 of Liabilities: $107,000.

(b) $7,000

(c) Column 2 of Assets (top to bottom): $15,000; $38,000; $47,000. Column 1 of Liabilities: $100,000.

32 13 (Key Question) Suppose the simplified consolidated balance sheet shown below is for the entire commercial banking system. All figures are in billions. The reserve ratio is 25 percent.



Liabilities and Net Worth





$ 52 ___

48 ___

100 ___

Checkable deposits

$200 ___

a. What amount of excess reserves does the commercial banking system have? What is the maximum amount the banking system might lend? Show in column 1 how the consolidated balance sheet would look after this amount has been lent. What is the monetary multiplier?

b. Answer the questions in part a assuming that the reserve ratio is 20 percent. Explain the resulting difference in the lending ability of the commercial banking system.

(a) Required reserves = $50 billion (= 25% of $200 billion); so excess reserves = $2 billion (= $52 billion - $50 billion). Maximum amount banking system can lend = $8 billion (= 1/.25  $2 billion). Column (1) of Assets data (top to bottom): $52 billion; $48 billion; $108 billion. Column (1) of Liabilities data: $208 billion. Monetary multiplier = 4 (= 1/.25).

(b) Required reserves = $40 billion (= 20% of $200 billion); so excess reserves = $12 billion (= $52 billion - $40 billion). Maximum amount banking system can lend = $60 billion (= 1/.20  $12 billion). Column (1) data for assets after loans (top to bottom); $52 billion; $48 billion; $160 billion. Column (1) data for liabilities after loans: $260 billion. Monetary multiplier = 5 (= 1/.20). The decrease in the reserve ratio increases the banking system’s excess reserves from $2 billion to $12 billion and increases the size of the monetary multiplier from 4 to 5. Lending capacity becomes 5  $12 = $60 billion.

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