Question

Use commercial bank and Federal Reserve Bank balance sheets to demonstrate the immediate effect of each of the following transactions on commercial bank reserves. Assume that the initial reserve ratio is 20 percent. Fill in the new balance in the column in the balance sheet that corresponds with each of the following transactions. Consider each transaction separately, not cumulatively. a. Federal Reserve Banks purchase $2 billion worth of securities from banks. b. Commercial banks borrow $1 billion from Federal Reserve Banks at the discount rate. c. The Fed reduces the reserve ratio from 20 percent to 19 percent. Instructions: Enter your answers as whole numbers in the gray-shaded cells of both tables below. d. Commercial banks increase their reserves after the Fed increases the interest rate it pays on reserves. Which of the columns above could represent this action

Answer 1

Answer and Explanation:

(a) In a situation were the Federal buys $2 billion worth of securities this should inturn leads to increase checkable deposits and commercial bank reserves by $2 billion. And with the demand deposits of $202 billion, required reserves are $40.4 billion, (20%× $202 billion).

Therefore, excess reserves are $1.6 billion ($42 billion - $40.4 billion) Hence the banking system can inturn increase the money supply (by making loans) by $8 billion more ( $1.6 billion x 5).

(b) In a situation where the commercial banks borrow $1 billion from the Fed. The commercial banks may now increase the money supply by making loans) by $5 billion ($1 billion x 5).

(c) Changing the reserve ratio in and of itself does not inturn change the balance sheets and if we are to assume that the reserve ratio has been reduced from 20 percent to 19 percent, required reserves will now be $38 billion ( 19%×$200 billion) and the commercial banks can now increase the money supply by making loans by $10.53 billion [$2 billion x (1/0.19)].

Hence : 19 %× $210.53 billion is $40 billion