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ECON 203 Lecture Notes - Lecture 12: Fractional-Reserve Banking, Reserve Requirement, Money Supply

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School
University of Calgary
Department
Economics
Course
ECON 203
Professor
Aamir Hashmi

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Document Summary

In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans. The boc makes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. Banks may hold more than the minimum. The reserve ratio r, is the fraction of deposits that banks hold as reserves. T-account: a simplified accounting statement that shows a banks assets and liabilities. A banks liabilities include deposits, assets include loans and reserves. When banks make loans, they create money, as the money supply is currency + deposits. Money multiplier: the amount of money the banking system generates with each dollar of reserves. For example, if r = 10%, 1/0. 1 = 10. Assets: besides reserves and loans, banks also hold securities. Liabilities: besides deposits, banks also obtain funds from issuing debt and equity. Bank capital: the resources a bank obtains by issuing equity to its owners.

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Related Questions

Assume that the banking system has total reserves of $100 million. Assume also that the reserve requirement for checking deposits is 10 percent and that banks do not hold any excess reserves. There is also no currency held by households.

a) What is the money multiplier? What is the money supply?

b) If the FED raises required reserves to 20 percent of deposits, what are the change in reserves and the change in money supply?

c) Now suppose the FED lowers the requirement from 10 percent to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

d) If the FED sells $1 million of government bonds, what is the effect on the economy's reserves and money supply? Use 10 percent required reserve ratio.

e) If the FED buys $5 million of government bonds, what is the effect on the economy's reserves and money supply? Use 10 percent required reserve ratio.

Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $400. Determine the money multiplier and the money supply for each reserve requirement listed in the following table.

Reserve Requirement Simple Money Multiplier Money Supply
(Percent) (Dollars)
20 Ā  Ā 
10 Ā  Ā 

A higher reserve requirement is associated with a money supply.

Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to worth of U.S. government bonds.

Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to to . Under these conditions, the Fed would need to worth of U.S. government bonds in order to increase the money supply by $200.

Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply.

  1. The Fed cannot control the amount of money that households choose to hold as currency.
  2. The Fed cannot prevent banks from lending out required reserves.
  3. The Fed cannot control whether and to what extent banks hold excess reserves.

1. In a system of fractional-reserve banking, even without any action by the central bank, the money supply declines if households choose to hold (less, more) currency or if banks choose to hold (less, more) excess reserves.

2. If the Fed makes an open-market purchase of government bonds, it will (decrease, increase) the money supply. Whereas if there is an increase in the discount rate on Fed lending, it will (decrease, increase) the money supply.

3. Chloe takes $100 of currency from her wallet and deposits it into her checking account. If the bank adds the entire $100 to reserves, the money supply(decreases, doesn't change, increases), but if the bank lends out some of the $100, the money supply (decreases, doesn't change, increases).

4. If the reserve ratio is 0.25 and the central bank increases the quantity of reserves in the banking system by $120, the money supply increases by how much?

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