Question

Refer to Table 16.2 and assume that the Fed’s reserve ratio is 10 percent and the economy is in a severe recession. Also, suppose that the commercial banks are hoarding all excess reserves (not lending them out) because they fear loan defaults. Finally, suppose that the Fed is highly concerned that the banks will suddenly lend out these excess reserves and possibly contribute to inflation once the economy begins to recover and confidence returns. By how many percentage points does the Fed need to increase the reserve ratio to eliminate one-third of the excess reserves? What is the size of the monetary multiplier before and after the change in the reserve ratio? By how much would banks’ lending potential decline as a result of the increase in the reserve ratio?

(1) Reserve Ratio, %	(2) Checkable Deposits, \(	(3) Actual Reserves, \)	(4) Required Reserves, \(	(5) Excess Reserve, \) (3-4)	(6) Money-Creating Potential of Single Bank, \(=5	(7) Money-Creating Potential of Banking System, \)
10 20 25 30	20,000 20,000 20,000 20,000	5,000 5,000 5,000 5,000	2,000 4,000 5,000 6,000	3,000 1,000 0 -1,000	3,000 1,000 0 -1,000	30,000 5,000 0 -3,333

Short answer

1. The Fed will increase the reserve ratio by 5%.
2. The size of the monetary multiplier before and after the change in the reserve ratiois 10 and 6.7, respectively.
3. The money-creating potential of banks has declined by $16,600 at 15% rr.

Step-by-step solution

For one-third of excess reserve

The excess reserve at 10% reserve ratio is $3000. Eliminating one-third of the excess reserve will give

$3000-\left\{\frac{1}{3}\times 3000\right\}=2000$

The new excess reserve becomes $2000. For an excess reserve to be $ 2000, the required reserve should be $3000 because the actual reserve is $5000 (given).

Suppose the required reserve ratio is x, the checkable deposits are $20,000(given), then

$$\begin{gathered} \frac{x}{100}\times 20,000=3000 \\ x=15 \end{gathered}$$

Thus, at a 15% reserve ratio, the excess reserve will be eliminated by one-third to become $2000. So, Fed will have to increase the rr by 5%.

Monetary multiplier

When the reserve ratio is 10%, the monetary multiplier will be

$\frac{1}{r}=\frac{1}{0.10}=10$

The monetary multiplier is 10.

When the reserve ratio becomes 15%, the monetary multiplier will be

$\frac{1}{r}=\frac{1}{0.15}=6.7$

The monetary multiplier is 6.7.

The lending potential of banks

The money creating potential or the lending potential of banks at a 10% reserve ratio is $30,000. The lending potential of banks at a 15% reserve ratio will be

$6.7\times 2000=13400$

The decline in bank’s lending potential is

$30,000-13400=16600$

The money-creating potential of banks has declined by $16,600.