Question

Assume the Fed has established a 10% required reserve ratio for checkable deposits. The Fed does not require banks to hold reserves for savings deposits. Further, assume that The First Idaho Bank is a primary dealer, which means that it is able to buy and sell securities directly to the U.S. Federal Reserve (Fed). Remember any bank in the U.S. can borrow from the Fed.

Provided below is the balance sheet for The First Bank of Idaho:

ASSETS		LIABILITES AND BANK CAPITAL
Asset Type	Amount	Liability/Bank Capital	Amount
Reserves	$50,000	Checkable Deposits	$200,000
Loans	$120,000	Savings Deposits	$100,000
Securities	$150,000
		Bank Capital	$20,000

What happens to the amount of loans The First Bank of Idaho can create after the Fed buys securities? What will happen to the size of the money supply if The First Bank of Idaho makes additional loans? Please explain your answers.

They can use their excess reserves of $80,000 to issue new loans. They will also have an $800,000 increase in their money supply.

The Use of Discount Policy: Bank Borrowing or Not Borrowing from the Fed

Go back to the original balance sheet. Suppose The First Bank of Idaho borrows $25,000 from the Fed. Show the effect of that transaction on The First Bank of Idaho’s balance sheet.

What happens to excess reserves at The First Bank of Idaho after the discount loan? Please explain your answer.

What happens to the amount of loans The First Bank of Idaho can create after the discount loan? What happens to the size of the money supply? Please explain your answers.

Rate on Reserves (This use of the Interest Rate on Reserves (IOR) is not a change in the required reserve ratio)

Go back to the original balance sheet. Congress approved a new tool for the Fed, the interest on reserves, before the Great Recession. Originally, the Fed was scheduled to begin using the new tool in 2010. However, when the Financial Crisis began in 2007, Congress allowed the Fed to use the tool in 2008. This tool allows the Fed to pay interest on reserves held at the Fed (so it doesn’t apply to reserves held as vault cash). The interest rate the Fed pays on required reserves is called the Interest Rate on Required Reserves (IORR); the interest rate the Fed pays on excess reserves is called the Interest Rate on Excess Reserves (IOER). We will assume the two interest rates are equal, we will call the joint interest rate on reserves, the Interest Rate on Reserves (IOR).

If the interest rate on reserves increases, will The First Bank of Idaho be more- or less-likely to hold excess reserves? What will happen to the amount of loans The First Bank of Idaho will make if the interest rate on reserves increases? What will happen to the money supply? Please explain your answers.

Answer 1