Question

The Federal Reserve purchases $1$ million in U.S. Treasury bonds from a bond dealer, and the dealer's bank credits the dealer's account. The reserve ratio is $15$percent. Assuming that no currency leakage occurs, how much will the bank lend to its customers following the Fed's purchase?

Short answer

As a result, the bank can lend its customers$\$850,000$ in excess reserves.

Step-by-step solution

Definition of the reserve ratio

The reserve ratio is an essential instrument of monetary policy in an economy, and it helps to regulate the money supply. When the central bank wishes to expand the money supply of the economy, it reduces the reserve ratio. The commercial banks would thus have more cash to lend out.

Funds to disburse in the form of loans

The Fed purchases $\$1$million dollars in US Treasury bonds, and the current reserve ratio is$15\%$

Loans to customers are calculated using excess reserves; they can be calculated as follows;

Loans to customers (excess reserves)$=$Transaction deposits - Required reserves

Transaction deposits $=\$1$million

Required Reserves $=15\%$of$\$1$million

$=\frac{15}{100}\times \mathrm{\$}1,000,000$

$=150,000$

Substituting the values:

Loans to customers $=$Transaction deposits $-$Required reserves

role="math" localid="1651583553360" $=\$1,000,000-\$150,000$

$=\mathrm{\$}850,000$

As a result, the bank can lend its excess reserves$\$850000$ to its customers.