Question

Suppose the Fed conducts an open market sale by selling $10 million in Treasury bonds to Acme Bank. Sketch out the balance sheet changes that will occur as Acme restores its required reserves (10% of deposits) by reducing its loans. The initial balance sheet for Acme Bank contains the following information: Assets – reserves 30, bonds 50, and loans 250; Liabilities – deposits 300 and equity 30.

a. Reserves decrease by $10 million, Loans decrease by $10 million

b. Reserves decrease by $10 million, Bonds decrease by $10 million

c. Reserves decrease by $10 million, Deposits decrease by $10 million

d. Reserves increase by $10 million, Bonds increase by $10 million

Answer 1

The Fed's open market sale of $10 million in Treasury bonds to Acme Bank results in the bank's reserves decreasing by $10 million. To maintain the required reserve ratio, Acme Bank reduces its loans by $10 million. The deposits and equity on the balance sheet remain unchanged. The correct answer is option a.

Step-by-step explanation:

When the Federal Reserve (the Fed) conducts an open market sale and sells $10 million in Treasury bonds to Acme Bank, Acme Bank will see a decrease in its reserves by $10 million as it pays for the bonds. Subsequently, Acme Bank's liabilities in the form of deposits do not change because it is purchasing the bonds with its reserves. However, to maintain the required reserve ratio, Acme Bank will need to adjust its loans accordingly.

Acme Bank's balance sheet initially has reserves of $30 million, so after purchasing the bonds, the reserves would decrease to $20 million. As the required reserve ratio is 10%, and the deposits remain at $300 million, Acme Bank must hold $30 million in reserves. To compensate for the reserve shortfall, Acme Bank will need to decrease its loans by $10 million. Therefore, the recovery process would involve Acme Bank decreasing its assets both by $10 million in reserves and by $10 million in loans (option a).

The adjusted balance sheet would show the reserves down to $20 million, loans down to $240 million, with the liability side remaining unchanged, keeping the deposits at $300 million and equity at $30 million. The open market operation by the Fed, in this case, causes Acme Bank to contract its lending.