Question

The following table shows the initial balance sheets of Bank A and The Federal Reserve (Fed). Suppose that the Fed then buys $10 million in bonds from Bank A.

Bank A

Assets	Liabilities
Bonds: $100 million	Deposits: $90 million
Reserves: $20 million	Shareholders' equity: $30 million
Total assets: $120 million	Total liabilities: $120 million

The Fed

Assets	Liabilities
Treasury bonds: $400 million	Reserves: $500 million
Other bonds: $400 million	Currency: $300 million
Total assets: $800 million	Total Liabilities: $800 million

a. What are the total assets and liabilities for Bank A after the transaction? Write down the new balance sheet for Bank A.

b. Excess reserves are reserves that banks hold beyond what they are required to hold to meet their reserve requirement. Assume that the reserve ratio is 10% What are the excess reserves for Bank A of before and after the transaction? What are the pros and cons for Bank A of holding excess reserves?

c. What are the total assets and total liabilities for the Fed after the transaction? Write down the new balance sheet for The Fed

d. Why would The Fed conduct such a transaction?

Answer 1

Solution

a.Balance Sheet of Bank A after the transaction :

Assets	Liabilities
Bonds: $90 million	Deposits: $90 million
Reserves: $20 million	Shareholders' equity: $30 million
Cash : $ 10 million
Total assets: $120 million	Total liabilities: $120 million

Reserves ratio is the % of it's total deposits that the banks are mandated by the FED to hold as reserves.

Any extra reserves that the banks hold beyond these mandated reserves are termed as excess reserves.

So there is no change in the excess reserves that the bank A holds before and after this transaction as it's total deposits did not change due to the transaction.i.e., it remains at $11 million ($20 million - (10 % of $90 million)

Advantages : The banks have less capital to lend so they carefully use it to lend to the good quality borrowers

They have higher buffer in case their business goes bad

Disadvantages : It is leading to comparitively less liquidity in the market.

Banks are loosing the opportunity of capital by not using it for lending but instead keeping it in as excess reserves

c.The Total of assets and liabiliies of the FED after the transaction

Assets	Liabilities
Treasury Bonds: $400 million	Reserves: $500 million
Other bonds: $410 million	Currency: $310 million
Total assets: $810 million	Total Liabilities: $810 million

d.Fed tries to purchase the bonds from the banks inorder to increase / induce liquidity into the economy.After this transaction,the banks have more capital left with them to lend to the public.

This is called open market operations.

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