(a.) Reserve requirement for banks is set at 5%. Your firm deposits its profits

Question

(a.) Reserve requirement for banks is set at 5%. Your firm deposits its profits of $28,000 into the Third National Bank. <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

How much excess reserve does your deposit generate for the bank?

What is the maximum amount of new money that can be created in the banking system as a result of this deposit? Show all work.

(b.) What is the Federal Funds Rate in the banking system?                                                    

Explain how the Fed manipulates this rate in order to achieve macroeconomic objectives.

Explanation / Answer

The Reserve requirement is given as 5%. So, the bank is required to keep (0.05*28000) of the given deposit. So, $1400 is kept as reserves.

Excess Reserves= Reserves-Required Reserves

                                = $(28000-1400)

                                =$ 26600

Now, the banks will be able to lend the remaining amount other than the required reserve ratio. This will have a multiplier effect depending on the required reserve ratio. The reserve ratio here is 5%. So, out of every $100 deposited $95 goes into circulation again. This $95 ultmately gets deposited into banks again. So, again the 5% reserve ratio applies there too.
This cycle continues - as more people deposit money and more banks continue lending it - until finally the $100 initially deposited creates a total of $2000 ($100 / 0.05) in deposits.

So, here the maximum amount of money created in the banking system as a result of this is $28000*(100/0.05)= $56000000.

b)Federal Funds Rate is the interest rate at which a depository institution lends immediate available funds toanother depository instituion overnight.

Interbank borrowing is essentially a way for banks to quickly raise liquidity. For example, a bank may want to finance a major industrial project but does not have the time to wait for deposits or interest (on loan payments) to come in. In such cases the bank will quickly raise this amount from other banks at an interest rate equal to or higher than the Federal funds rate.

Raising the federal funds rate will discourage banks from taking out such inter-bank loans, which in turn will make cash that much harder to procure. Conversely, dropping the interest rates will encourage banks to borrow money and therefore invest more freely. Thus this interest rate acts as a regulatory tool to control how freely the economy operates.

      In simple terms, higher the rate lower the liquidity in the economy and lower the rate higher the liquidity in the market.

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