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.
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:
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.