(5) Currently, the required reserve ratio for banks is 0%. Please explain what required reserves are,...

(5) Currently, the required reserve ratio for banks is 0%. Please explain what required reserves are, what a 0% required reserve ratio means and why the Federal Reserve may want to set a 0% required reserve ratio right now. If the required reserve ratio returns to 10% after the coronavirus crisis, then what would we expect to be the increase in commercial bank deposits following a one-dollar open market purchase? Show all work.

Solutions

Expert Solution

The reserve ratio is the portion of reservable liabilities that commercial banks hold onto, rather than lend out or invest. This is kept to meet out the withdrawal demands by customers for their time deposits.The required reserve ratio is used as a tool in monetary policy, influencing the country's borrowing and interest rates by changing the amount of funds available for banks to loan out.
In this situation of crisis reserve requiremnet is 0 as government wants to keep the money to lend out the money to people in need and having a no reserve lowers down the interest rate. So it solves two purposes, more amount to lend and a lower interest rate, thus making money available to lmore people.

If after the crisis Reserve Requiremnt is increased to 10%, then with a single dollar of invest ment huge returns can be brought into the market which can be understood by the concept of money multiplier. The multiplier is given by the formula (1/reserve ratio), here it is 1/0.1 which equals 10.

So with this we see that with a $1 open market purchase, the final amount in the market would end upto $10.

It can be understood as follows:
(assuming that the amount of open market purchase is invested by people which is routed through banks, and banks again lend the money out after keeping reserves and the cycle continues)

Amount	Investment	Reserves	Loaned Out
1	1	0.1	0.9
0.9	0.9	0.09	0.81
0.81	0.81	0.081	0.729
0.729	0.729	0.0729	0.6561
0.6561	....	....	...
....	.....	....	....
10	10	1	9

The last row mentions the total of all the columns. And we see after the cycle ends up where there are no more money to be brought into the market, the total amount generated is 10 times the initial amount.

Rahul Sunny answered 4 weeks ago

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