Question

Explain what would happen if banks were notified they had to increase their required reserves by one percentage point from, say, \(9 \%\) to \(10 \%\) of deposits. What would their options be to come up with the cash?

Short answer

If banks are required to increase their reserve ratio from 9% to 10% of deposits, they have several options to come up with the additional cash: 1. Reduce lending, which may negatively impact economic growth 2. Attract more deposits by offering higher interest rates or implementing promotional campaigns 3. Borrow from other banks through interbank lending at the federal funds rate 4. Borrow from the central bank through emergency lending facilities, although this is typically more expensive and may carry a stigma of financial weakness. Each option has its own pros and cons, and banks must carefully consider which approach to take based on their specific circumstances.

Step-by-step solution

Understanding Reserve Requirements

Reserve requirements are regulations set by central banks that require commercial banks to hold a specified percentage of their deposits as reserves. In this case, the reserve requirement is increased from 9% to 10%. This means that for every dollar deposited in a bank, the bank must hold 10 cents in reserve, up from 9 cents.

Consequences of an Increased Reserve Requirement

When the reserve requirement is increased, banks need to find ways to come up with the additional cash required to meet the new requirement. This reduces the amount of money banks have available for lending, which may result in reduced credit creation and possibly an impact on the broader economy.

Option 1: Reduce Lending

One option for banks to meet the new reserve requirement is to reduce lending. By approving fewer loans or reducing the amount of credit extended to customers, banks can build up their reserves to meet the new requirements. This may have negative effects on economic growth, as businesses and individuals may face tighter credit conditions, making it harder to invest or consume.

Option 2: Attract More Deposits

Another option for banks is to attract more deposits in order to increase their reserves. This can be achieved by offering higher interest rates on deposits or implementing various promotional campaigns. By increasing their deposits, banks can raise the amount of money they have in reserve, allowing them to meet the new reserve requirement.

Option 3: Borrow from Other Banks

Banks can also borrow reserves from other banks to meet the new reserve requirement. This is done through interbank lending, where banks with excess reserves lend to banks in need of additional reserves. The interest rate at which these loans are made, known as the federal funds rate, is determined by market forces.

Option 4: Borrow from the Central Bank

If banks cannot meet the new reserve requirement through the above methods, they can borrow directly from the central bank. Central banks typically provide emergency lending facilities, known as discount windows, through which banks can borrow reserves to cover short-term liquidity needs. By borrowing from the central bank, banks can meet the increased reserve requirement. However, this option is usually more expensive than borrowing from other banks and may carry a stigma of financial weakness. In summary, when faced with an increased reserve requirement, banks have several options to come up with the additional cash: reduce lending, attract more deposits, borrow from other banks, or borrow from the central bank. Each of these options has its own pros and cons, and banks need to carefully consider which option to choose depending on their specific circumstances.