Question

Mr. Jones is president of the First National Bank of St. Louis and wishes to determine if his bank is holding too much of its demand deposits as reserves. The bank's total deposits = \(\$ 1,700,000\) and the reserve ratio is \(20 \%\). If Mr. Jones finds that reserves \(=\$ 850,000\) what might he conclude about excess reserves?

Short answer

Mr. Jones can conclude that the First National Bank of St. Louis is holding \(\$ 510,000\) in excess reserves since the actual reserves (\(\$ 850,000\)) are higher than the required reserves (\(\$ 340,000\)).

Step-by-step solution

Calculate the required reserves

To find the required reserves, multiply the total deposits by the reserve ratio. Required reserves = Total deposits x Reserve ratio

Convert the reserve ratio to a decimal

In our case, the reserve ratio is given as 20 percent. Convert the percentage to a decimal by dividing by 100. \(0.20 = \frac{20}{100}\)

Multiply the total deposits by the reserve ratio in decimal form

Now, multiply the total deposits of \( \$ 1,700,000 \) by the reserve ratio in decimal form (0.20). Required reserves = \(\$ 1,700,000\) x 0.20 = \(\$ 340,000\)

Compare the required reserves to the actual reserves

In this step, compare the required reserves we calculated, \(\$ 340,000\), to the actual reserves given, which is \(\$ 850,000\).

Determine if there are excess reserves

Since the actual reserves (\(\$ 850,000\)) are higher than the required reserves (\(\$ 340,000\)), we can conclude the bank is holding excess reserves. To find the amount of these excess reserves, subtract the required reserves from the actual reserves. Excess reserves = Actual reserves - Required reserves = \(\$ 850,000 - \$ 340,000 = \$ 510,000\) Mr. Jones can conclude that the First National Bank of St. Louis is holding \(\$ 510,000\) in excess reserves.

Key concepts

Demand Deposits

Demand deposits represent the money held in accounts at banks that can be withdrawn at any time without any prior notice. These are the standard accounts that people use for everyday transactions, such as paying bills, making purchases, or transferring money to others. Demand deposits play a crucial role in the banking system as they provide the necessary liquid reserves that banks need to function efficiently and meet the withdrawal demands of their customers.

Given the nature of demand deposits, banks must be prepared to handle sudden withdrawals, which is why a reserve requirement is in place. This helps ensure that the bank can meet its customer obligations at any time.

Excess Reserves

Excess reserves are the funds that a bank holds over and above the required reserves. These are reserves held beyond what is necessary to meet the central bank's reserve requirements. In Mr. Jones's case, the First National Bank of St. Louis holds excess reserves because its actual reserves exceed the required amount.

• Actual reserves: The total money a bank has on hand or in its reserves.
• Required reserves: The minimum amount that must be kept, based on the central bank's rules.
• Excess reserves: The surplus remaining after accounting for the required reserves.

Having excess reserves can be seen as a cautious strategy, providing an additional buffer. However, it also means that the bank is not using those funds to their full potential to make loans, which could generate additional income.

Reserve Ratio

The reserve ratio is the fraction of demand deposits that a bank must hold as reserves. This ratio is determined by the central bank and ensures that banks have enough liquidity to cover withdrawals by their customers.
The reserve ratio is usually represented as a percentage. For example, a 20% reserve ratio means that for every \\(100 in demand deposits, the bank must hold \\)20 in reserves.
To convert the reserve ratio into a usable form, banks divide the percentage by 100 to get a decimal. This decimal is then used in calculations to determine the required reserves.
An adequate reserve ratio is critical for stability, providing assurance that banks can meet withdrawal demands, especially during times of financial stress or uncertainty.

Required Reserves

Required reserves are the minimum amount of reserves a bank must hold based on the total demand deposits and the reserve ratio. These reserves ensure that a bank can meet withdrawal demands without experiencing liquidity issues.

In the example of the First National Bank of St. Louis, to find the required reserves, we multiply the total demand deposits by the reserve ratio: \[\text{Required Reserves} = \text{Total Deposits} \times \text{Reserve Ratio} \] Given that the total deposits are \$1,700,000 and the reserve ratio is 0.20, the required reserves would be calculated as \[ 1,700,000 \times 0.20 = 340,000.\]

These required reserves ensure the bank maintains a balance between being able to operate day-to-day, while still having enough funds to meet the reserve requirement.