Question

Why might banks want to hold excess reserves in time of recession?

a) To prevent customers from withdrawing their deposits
b) To increase interest rates on loans
c) To cover potential deposit withdrawals
d) To invest in riskier financial assets

Answer 1

During a recession, banks may hold excess reserves primarily to cover potential deposit withdrawals, ensuring they can meet customers' liquidity demands and protect against bank runs.

Step-by-step explanation:

In times of economic uncertainty, such as a recession, banks may want to hold excess reserves for several reasons. One of the main reasons is to cover potential deposit withdrawals (choice c), as customers may withdraw more funds during such periods due to fear and uncertainty. Holding excess reserves helps banks ensure they can meet these obligations without facing liquidity issues. Additionally, when the economy contracts, banks face a higher risk that loans will not be repaid, increasing the need for a safety net in the form of excess reserves.

Banks are legally mandated to hold a minimum reserve, but holding excess reserves gives them additional security. This precautionary measure helps banks deal with a higher rate of non-repayment of loans during recessionary periods, as well as providing a buffer against potential bank runs, where many customers seek to withdraw their deposits simultaneously.