Suppose that the reserve requirement is 10 percent and the balance sheet of the

Question

Suppose that the reserve requirement is 10 percent and the balance sheet of the People's National Bank looks like the accompanying example. a. Indicate how the bank's balance sheet would be altered if it extended this loan (show the new t-account). b. Suppose that the required reserves were 20 percent. If this were the case, would the bank be in a position to extend any additional loans? Explain Assets Liabilities Vault Cash $20,000 Checking deposits $200,000 Deposits at Fed $30,000 Net Worth $15,000 Securities $45,000 Loans $120,000

Explanation / Answer

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Suppose the Fines-Nearcome bank has the following assets and liabilities:

Assets (owed to bank) Liabilities (owed by bank)

vault cash 120,000 checking deposits 1,400,000

deposit at Fed 80,000 net equity 400,000

loans outstanding 1,500,000

U.S. bonds100,000

From the above, we can find the actual reserves of this bank. Actual reserves are vault cash plus

deposits at the Fed, so for this bank, those total 120,000+80,000=$200,000.

Notice that no other assets of the bank count as reserves, even though they represent payments owed to the bank. The

bank's bonds and loans are not reserves.

If we know the required reserve ratio, we can use the above information to determine whether

this bank can make any loans, whether the whole banking system can generate new deposits, and

how large the amount of new deposits might be. Suppose the required reserve ratio is 10%. The

bank's required reserves are based on its deposit liabilities only (in this case, checking deposits).

For this bank, the required reserves would be 10% of $1,400,000 or .1 x $1,400,000 = $140,000. Notice

that no asset of the bank enters into figuring required reserves, since the purpose of required

reserves is to back up the money the bank OWES to others.

Since this bank has actual reserves of $200,000, but required reserves of $140,000, it has excess

reserves of $200,000-$140,000= $60,000. The bank could thus safely part with $60,000 of reserves

and still be legal. If the bank makes a loan of $60,000, and that money is spent and deposited in some

other bank, this bank will lose reserves (probably out of its Fed deposit). Its new situation will look like

Assets (owed to bank) Liabilities (owed by bank)

vault cash 120,000 checking deposits 1,400,000

deposit at Fed 20,000 net equity 400,000

loans outstanding 1,560,000

U.S. bonds 100,000

Actual reserves are now 120,000+20,000=$140,000, which is just enough to cover the required

reserves, which are still 10% of the $1,400,000 deposits.

While this bank can only make a loan of $60,000, the entire banking system might produce as

much as $60,000

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