Question

Why are banks holding so many excess reserves and why is the money multiplier less than one? (500 - 650 word explanation please!)

Answer 1

Excess reserve have grown dramaticlly since the financial crises. Holding excess reserves is now much more attractive to banks because the cost of doing so is lower now that the federal reserve pays interest on those reserves. The fact that banks are holding excess reserves in response to the risks and interest rates that they face suggests that the reserves are not likely to cuse large, unexpected increase in bank loan portfolios. However, it is not clear what banks are likely to do in the future when the perceived condition change. Since the finncial crised,Americn banks have increased their excess reserves that is, the cash funds they hold over and above the federal reserve's requirements. Excess reserves grew from $1.9 billion in August 2008 to $2.6 tillion in January 2015. The crises has altered the trade-off that banks make when calculating their desired levels of excess reserves. Banks now encounter an environment where holding reserves is much more attractive because the cost of holding them - in the form of foreign interest - is siginificantly lower than it ws before the crises. The federal reserve has embarked on several policies designed to pump large amount of reserves into the banking system, fostering conditions in which it is both easier and more attractive for banks to hold huge amount of ecess reserve. One reason bank hold reserve is because they are required to. Currently the Federal Reserve's Board of Governors mandates that, for net transaction accounts in 2015, the first $14.5 million will be exempt from reserve requirements. A 3% reserve ratio will be assessed on net transaction accounts over $14.5 million and a 10% reserve ratio will be assessed on net transaction accounts in excess of $103.6 million. Any balance held above this threshold are considered excess reserve. Banks also hold reserve to meet their unknown needs for liquidity. Banks measure the cost of carrying more reserves by comparing what they might earn by parking the funds in an alternative asset with the cost of last minute borrowing to cover an unforeseen shortfall in reserves. The optimal level of excess reserves is usually not zero, because liquidity needs are not perfectly known beforehand. To deal with the 2008 financial crises, the Federal Reserve pumped large amount of reserve into the banking system and introduced new programs that altered the term of the trade-off banks make when deciding their level of excess reserve. In short the marginal benefits of holding additional reserves has increased, whereas the marginal cost has decreased. As a result of these new Federal Reserve plicies, holding reserves is now much more attractive to banks. The actual ratio of money to central bank money, also called the money multipier, is lower because some funds are held by the non-bank public as currency. Money multiplier will be greater than one if the reserve ratio is less than one. Since bank would not be able to make any loan if they kept 100% reserve, we can expect that the reserve ratio will be less than one.