suppose a bank received a new deposit of 3750 and faces a reserve requirement of 12.5%. assuming that the bank gives no further loans. how much does its excess reserves increase?
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Answer:
The required reserve ratio gives the percent of deposits that banks must hold as reserves. It is the ratio of required reserves to deposits. If the required reserve ratio is 10 percent this means that banks must hold 10 percent of their deposits as required reserves. If deposits are $20 million, then $2 million ($20 million x .10) must be held as required reserves.
Excess reserves are reserves over and above required reserves. If total reserves are $5 million and required reserves are $2 million, then excess reserves are $3 million ($5 million less $2 million).
If the banking system were to loan out its entire excess reserves, the money supply would expand initially by $3 million. However, as this money circulates through the system, there would be further increases in the money supply. The maximum amount by which demand deposits can expand is given by the equation:
ADD = AER/r.
ADD is the expansion of demand deposits, AER is the excess reserves in the banking system, and r is the required reserve ratio. Thus, the maximum amount by which demand deposits can expand is equal to $30 million ($3/0.10).