Problem 6 Suppose Bank A borrows reserves ... [FREE SOLUTION]

Chapter 13: Problem 6

Suppose Bank A borrows reserves from Bank B. Now that Bank A has more reserves than previously, will the money supply increase? Explain your answer.

Short Answer

Expert verified

No, the money supply will not increase just because Bank A borrows reserves from Bank B. The total reserves in the banking system remain the same, it only changes the distribution of reserves among the banks.

Step by step solution

Understand monetary reserves

In a banking system, monetary reserves refer to the minimum fraction of customer deposits and notes that each bank must hold as liquid assets (cash or deposits at the central bank). The surplus reserves can be loaned out to other banks, entities or individuals, leading to the creation of new deposits and thus expanding the money supply.

Analyze the transaction

In this case, Bank A borrows reserves from Bank B. This movement of reserves doesn't represent an addition of new reserves to the banking system, but a transfer from Bank B to Bank A. Bank A's reserves increase but Bank B's reserves decrease. As a result, the total reserves in the system remain the same.

Conclude the effect on money supply

Since the total reserves in the banking system remain unchanged, there won't be a significant change in the system's ability to create new loans and thereby expand the money supply. The transaction just changes the distribution of reserves among banks, not the total amount.