Question

Suppose a commercial bank has \(\$ 600,000\) in demand deposits, has made \(\$ 375,000\) worth of loans and investments, and has \(\$ 25,000\) in excess reserves. Assuming that the bank's initial reserves were provided exclusively by deposits, what must be the required reserve ratio of the banking system?

Short answer

The required reserve ratio of the banking system is \(33.33\%\).

Step-by-step solution

Identify the given values

We are given the following values: - Demand deposits: $600,000 - Loans and investments: $375,000 - Excess reserves: $25,000 We need to find the required reserve ratio.

Find the total reserves

The total reserves of the bank are the sum of the required reserves and excess reserves. We know the excess reserves, but we don't know the required reserves yet. We can calculate the required reserves by considering that the bank's reserves came exclusively from deposits. Total reserves = Required reserves + Excess reserves We know the total loans & investments made by the bank. The remaining amount will be the required reserves plus excess reserves. So, Total reserves = Demand deposits - Loans and investments Total reserves = \(600,000 - \)375,000 = $225,000

Calculate required reserves

Now that we have the total reserves, we can subtract the excess reserves to find the required reserves. Required reserves = Total reserves - Excess reserves Required reserves = \(225,000 - \)25,000 = $200,000

Calculate the required reserve ratio

The required reserve ratio is the ratio of the required reserves to the demand deposits. We can now calculate the required reserve ratio: Required reserve ratio = Required reserves ÷ Demand deposits Required reserve ratio = \(200,000 ÷ \)600,000 Required reserve ratio = 0.3333 or 33.33% The required reserve ratio of the banking system is 33.33%.

Key concepts

Demand Deposits

Demand deposits are funds held in bank accounts from which the account holder can withdraw money at any time without any prior notice. These funds are commonly kept in checking accounts. The available money can be accessed through checks, ATMs, or online banking transactions.

• Accessibility: Demand deposits provide instant access to funds, which is why they are popular for everyday transactions.
• No Interest: Typically, these accounts do not earn interest because of their high liquidity.

Understanding demand deposits is crucial since they form the base from which banks calculate their reserves for lending and are a key component in determining how much money a bank can create through loans.

Excess Reserves

Excess reserves refer to the capital reserves held by a bank or financial institution that exceed the required minimum by the central bank or any regulatory authorities. Essentially, these are the extra funds a bank keeps beyond what they are mandated to keep as a safety buffer for withdrawals or unexpected financial demands.

• Safety Net: By retaining excess reserves, banks ensure they have enough liquidity to satisfy abrupt withdrawal demands.
• Opportunity Loss: While holding excess reserves is safe, it can also mean missed opportunities to earn interest through loans or investments.

Excess reserves play an essential role in a bank's financial strategy, ensuring liquidity and reflecting the bank's tolerance to risk.

Loans and Investments

Loans and investments are critical ways banks generate revenue. When a bank receives deposits, it uses these funds to provide loans to borrowers like individuals or businesses, as well as make strategic investments. This acts as the primary source of income for banks.

• Loans: By lending out money, banks charge interest, which becomes their profit.
• Investments: Banks also invest in securities which can bring returns either through interest or capital gains.

Understanding loans and investments is vital as they are fundamental to how banks operate, stimulating economic growth by providing capital to those who need it.

Total Reserves

Total reserves are a sum of a bank's required reserves and its excess reserves. Required reserves are set by a central authority to ensure the bank can meet depositor demands, whereas excess reserves are any additional funds kept beyond this requisite.

• Formula: Total reserves = Required reserves + Excess reserves.
• Provisioning: They provide a buffer for financial stability and act as a bank's first line of defense in financial distress situations.

Total reserves ensure a bank’s capability of coping with day-to-day operations and economic shifts by keeping them prepared for withdrawals or any sudden liquidity demands.