Question

Consider the U.S. banking system prior to October 2008. If there were no excess reserves in the banking system and the Fed lowered the required reserve ratio, it follows that banks would have _____, which they could use to extend loans and create new _____.

a) Surplus funds; investments
b) Increased reserves; deposits
c) Limited liquidity; assets
d) Decreased capital; liabilities

Answer 1

Lowering the required reserve ratio gives banks surplus funds, allowing them to create new loans and deposits, bolstering economic activity through the money multiplier effect.

Step-by-step explanation:

When the Federal Reserve lowers the required reserve ratio, banks have increased reserves that were previously tied up. This leads to banks having additional funds which they can use to extend more loans. In a banking system where there were no excess reserves prior to the reduction in reserve requirements, the reduction would suddenly create excess reserves that could then be used to extend credit. As these loans are circulated through the economy, they result in the creation of new deposits due to the money multiplier effect.

When the Fed lowers the required reserve ratio in the U.S. banking system prior to October 2008, banks would have increased reserves which they could use to extend loans and create new deposits. With a lower reserve ratio, banks are required to hold a smaller percentage of deposits as reserves, allowing them to lend out a larger portion of their deposits.