Suppose that in a country the total holdings of banks were as follows: required reserves = $45 million excess reserves = $15 million deposits = $750 million loans = $600 million Treasury bonds = $90 million Show that the balance sheet balances if these
are the only assets and liabilities. Assuming that people hold no currency, what happens to each of these values if the central bank changes the reserve requirement ratio to 2%, banks still want to hold the same percentage of excess reserves, and banks don't change their holdings of Treasury bonds? How much does the money supply change by?
The only liability is deposits which equal $750 million. Total reserves are $60 billion which summed with loans, $600 million, and Treasury bonds $90 million = $750 . Since liabilities equal assets, the balance sheet balances.
Initially banks need to hold 6% on reserve and want to hold 2% as excess reserves. When the Fed lowers the reserve requirement ratio to 2%, the bank only has to hold $15 million on reserve and so now has $30 million of excess reserves. Between the 2% requirement and the 2% for excess the reserve ratio is now 4% and the multiplier is now 1/.04 = 25 . So, the decrease in the reserve requirement ratio leads to an increase in deposits of $750 million.
(Also, total reserves are $60 million and the multiplier is now 25, so deposits should be $1,500 million.)
Required reserves are 2% of $1,500 million of deposits = $30 million.
Excess reserves are 2% of $1,500 million of deposits and so now also equal $30 million.
Deposits rose by as much as the money supply since people don't hold currency, so that the money supply rose by $750 million. The additional deposits came by way of additional lending, so loans should have also increased by $750 million. Also, since deposits rose by $750 million, liabilities should have risen by $750 million. Under the given assumptions, this means loans should have risen by $750 million.
Overall the money supply rose by $750 as explained above.
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