Question

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 20%. The Federal Reserve buys a government bond worth $1,500,000 from Manuel, a customer of First Main Street Bank. He deposits the money into his checking account at First Main Street Bank.

Complete the following table to reflect any changes in First Main Street Bank's T-account.
Assets Liabilities
Reserves/deposits/net work/loan Reserves/deposits/net work/loans
Complete the following table to show the effect of a new deposit on excess and required reserves when the required reserve ratio is 20%.
Hint: If the change is negative, be sure to enter the value as negative number.
Amount Deposited Change in Excess Reserves Change in Required Reserves
(Dollars) (Dollars) (Dollars)
Now, suppose First Main Street Bank loans out all of its new excess reserves to Latasha, who immediately uses the funds to write a check to Jake. Jake deposits the funds immediately into his checking account at Second Republic Bank. Then Second Republic Bank lends out all of its new excess reserves to Nick, who writes a check to Rosa, who deposits the money into her account at Third Fidelity Bank. Third Fidelity lends out all of its new excess reserves to Alyssa as well.
Fill in the following table to show the effect of this ongoing chain of events at each bank.
Increase in Deposits Increase in Required Increase in
Reserves Loans
(Dollars) (Dollars) (Dollars)
First Main Street Bank
Second Republic Bank
Third Fidelity Bank

Answer 1

Acme Bank's balance sheet changes due to a Federal Reserve open market sale include a decrease in reserves by $10 million, an equal increase in bonds held, and a decrease in loans by $10 million to restore required reserves at 10% of deposits.

Step-by-step explanation:

When the Federal Reserve conducts an open market sale, it means banks are purchasing government securities from the Fed which results in a decrease in the bank's reserves. In the scenario provided where Acme Bank purchases $10 million in Treasury bonds from the Fed, this will directly reduce the bank’s reserves by $10 million. Since the required reserve ratio is 10%, Acme Bank would now have to adjust its balance sheet to maintain this ratio. The initial balance was reserves at $30 million, bonds at $50 million, and loans at $250 million. After the purchase, the bank's reserves would shrink to $20 million ($30 million - $10 million), assuming bonds increase to $60 million, and deposits remain at $300 million. To meet the reserve requirement of 10% of deposits, Acme Bank needs to have $30 million in reserves ($300 million * 10%), resulting in a deficit of $10 million in reserves.

To restore required reserves, Acme Bank will reduce its loans, likely by calling in loans or not issuing new ones, until its reserves are back to the required level. Since it is short $10 million, Acme Bank would need to reduce its loans by the same amount. The new loans amount would be $240 million ($250 million - $10 million).

After these changes, Acme Bank's balance sheet would reflect reserves at $20 million, bonds at $60 million (assuming that all the bonds are recognized as assets), and loans at $240 million. The equity would remain the same at $30 million unless the bank's net worth is affected by the changes in assets.