Question

Consider a situation where more people in the US withdraw money from their bank accounts and hold more currencies. Use the graph of the Market for Bank Reserves to illustrate how the Federal Reserve would react to this change assuming the reserve requirements and the demand for excess reserves remain unchanged

Answer 1

The Federal Reserve System, also known simply as the Fed, is the central bank of the United State. The Fed has several important functions such as, supplying the economy with currency, holding deposits of banks, lending money to banks, regulating the money supply and supervising the banking system. Most modern economies are based on a fractional-reserve banking system. Fractional reserve banking is designed to assure that banks have enough liquid assets (reserves) on hand to satisfy the normal withdrawals made from checking account deposits. Actual Bank Reserves = Bank deposits held at the Fed. + Bank Vault Cash. Both of these assets are readily available to satisfy customer withdrawals or transfer to other banks as customers write checks. The Fed. establishes a Required Reserve Ratio which is the percentage of checkable account deposits that the banks are required to hold as reserves. Thus the Minimum required reserves = Required Reserve Ratio X Checkable deposits

The Fed controls interest rates through commercial bank reserves. This is why students need to understand the role of the banking system to fully understand the conduct of monetary policy. Bank reserves are currency held by banks either in their vault (this is sometimes called vault cash) or deposited in an account with one of the 12 Federal Reserve Banks. Reserves are divided into two types: required reserves (a percent of commercial bank deposits that the Fed requires banks to keep on hand or in reserve) and excess reserves (any reserves held by banks above the required amount). The Fed affects bank reserves through open market operations. Open market operations involve the Fed policy action of buying and selling U.S. government securities (e.g., Treasury bonds). This action is called “open market” operations because the Fed does not decide on its own which securities dealers to deal with. Various securities dealers compete in the open market to buy/sell securities based on the price. When prices are high, dealers buy fewer bonds; when prices are low, they buy more bonds. When the Fed purchases bonds, it takes bonds out of the economy as bondholders submit their bonds for sale. The Fed pays for them with a check. This action puts more money into the economy. When the Fed sells bonds, it puts more bonds into the hands of banks and individuals and takes money out of the economy as payment. By changing the amount of money in the economy, the Fed changes the supply of funds available for loans. When there is plenty of money available for loans, the price of loans (the interest rate) will be low. When there are few funds available for loans, borrowers will compete for the limited funds, driving up the price.

How the Effect of a Policy Change Multiplies For any initial change in bank reserves, the money supply will change by some multiple of that amount. In introductory economics courses, students are first introduced to the simple money multiplier, equal to 1 over required reserve ratio. Using the simple money multiplier: ∆ in checkable deposits = 1/r * ∆ in excess reserves An injection of new deposits into the banking system will have a “multiplier” effect on bank deposits. When a bank receives a new deposit, it must keep a certain percentage of the new deposit either as vault cash or on deposit with the Fed (these are the required reserves dictated by the Fed). The remainder of the deposit becomes excess reserves and may be loaned out by the bank. Because banks are profit-maximizing firms that earn profits from making loans, they will generally loan out as much of their excess reserves as possible. Thus, the excess reserves from the new deposit become loans. When the loan check is deposited into the borrower’s account (either at the same bank or another bank) the loan amount becomes another new deposit. Because the required reserves are held at each stage, the amount becomes smaller as it multiplies through the banking system. The bank must hold the required amount of reserves from the new deposit, and the remainder become excess reserves that can be loaned out. This process continues until there are no further new deposits/loans to be made. However, the size of the effect of an open market purchase of bonds on the economy depends on whether or not the funds from the Fed’s purchase end up in the banking system. There are two important ways in which the amount of the bond purchase could “leak out” of the multiplier process. If the proceeds of the purchase are held by the seller as cash (rather than deposited in a bank account), the injection of money into the economy will not multiply. This is sometimes called “currency drain.” The payment also will not multiply if the bank into which the proceeds of a bond purchase are deposited holds the payment as excess reserves (rather than loaning it out). This may be the case if banks cannot locate “creditworthy” borrowers. The actual money multiplier will be smaller if the open market purchase is held as currency or excess reserves and is not allowed to “multiply” through the banking system. The actual money multiplier is 1/(r + e + c) Where: r = the percentage of deposits banks are required to hold e = the percentage of deposits banks hold as excess reserves c = the percentage of deposits borrowers hold as cash Depositors’ decisions about holding currency, banks’ decisions about holding excess 12 A Curriculum Module for AP Macroeconomics reserves, and the Fed’s decision about the reserve requirement all impact the size of the multiplier effect on changes in open market operations. As can be seen using the actual money multiplier, the ultimate effect of the Fed’s open market purchase (or sale) of bonds is different depending on whether the purchase (or sale) is from a bank or from the nonbank public. If the Fed purchases $1,000 of bonds from a bank, the securities held by the bank decrease by $1,000 and the Fed pays the bank with a $1,000 check. The check represents a $1,000 increase in the bank’s excess reserves (the entire amount is excess reserves, because the check does not represent a deposit into an individual’s bank account — so no required reserves must be held). The bank has merely changed from holding a bond to holding excess reserves. The bank may then loan out the excess reserves. The change in excess reserves that can be multiplied is $1,000. The maximum increase in the money supply is $1,000 times the multiplier (1/r). If, however, the Fed purchases bonds from the nonbank public, the result is different. The securities held by the nonbank public will decrease by $1,000 and the Fed pays the nonbank public with a $1,000 check. The person receiving the check MAY deposit the $1,000 in a bank account but may also cash the check and hold currency. If the person holds the $1,000 as currency, reserves are unchanged. But if the person deposits the $1,000 in a bank account, reserves increase by $1,000, but the reserves are NOT all excess reserves. The bank accepting the deposit must hold the required percentage of the deposit as required reserves. Therefore, the maximum increase in the money supply is [$1,000 – ($1,000 x r)] * 1/r For example, if the reserve requirement is 10 percent, the bank must hold $100 as required reserves and only has an additional $900 to loan. Thus the multiplier process starts with $900 rather than the full $1,000 (as when the Fed purchased the bonds directly from the bank).