Question

6. we noted that in ancient times money was normally created by government. However, under the modern banking system in the U.S. and other developed countries, money is normally created by Banks. The process begins when a depositor brings, let’s say, $100 in M1 into the bank for deposit. The bank accepts the deposit and creates a Demand Deposit (DD) for the customer in the amount of $100. The bank now has $100 in liquid funds it did not have before. As discussed in class, there are three things the bank can do with this new money: 1) It can keep the money as Vault Cash (a lot of it inside of ATM machines), 2) It can place the money on deposit at the Federal Reserve Bank (Fed) to be held as Reserves, 3) It can purchase securities for the bank’s securities portfolio. The contents of the bank’s security portfolio will not be included in M1. What is it about the definition of M1 that precludes the inclusion of the bank’s securities portfolio?

7. As discussed in class, all bank deposits at the Federal Reserve Bank (Fed) qualify as Reserves. However, not all Reserves are the same. The Fed makes a distinction between Required Reserves, and Excess Reserves. What is the difference between Required Reserves and Excess Reserves?

Answer 1

6). The central bank of a nation divides the whole money supply of an economy into different parts like M0, M1, M2, M3, M4. This helps them in understanding and evaluating the impact of their monetary decisions on the money supply.

M0 and M1 are called narrow money. It includes cash in circulation, demand deposits and cash equivalents which can be easily converted into cash. However, the securities which are mentioned in the question are not highly liquid which means that they cannot be converted into cash when required immediately. The whole procedure of selling securities takes times. This is the reason we do not include the securities in M1.

7). The required reserve ratio is the percentage of the deposits which the bank should keep with themselves as reserves. This is set by the central bank. For example, total deposits are $10,000 dollars and the reserve ratio is 20%. So, the banks have to keep 20% of 10,000 i.e 2,000 as the required reserves. This is the amount which banks cannot use for giving credits. It has to be kept by the bank in form of reserves.

Bank reserves = required reserves + excess reserves

So from the equation, we can see that excess reserves is the extra amount of reserves which are kept by banks willingly. These reserves are not mandated by the central bank. Banks keep these reserves for unforeseen events.

So, from the above description, we can easily find out the difference between required reserves and excess reserves. The reserves mandated by the central bank are called required reserves and extra reserves apart from the required reserves kept by the bank willingly are called excess reserves.