Problem 34 Explain what would happen if ban... [FREE SOLUTION]

Chapter 15: Problem 34

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

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If banks had to increase their required reserves from 9% to 10% of deposits, they would need to come up with cash equal to 1% of their deposits (\(0.01D\)). To do this, they have several options: 1. **Reducing loans and other investments**: Banks can free up funds by decreasing their loan portfolio and selling securities such as bonds or stocks. 2. **Attracting more deposits**: To raise cash, banks can offer new products or higher interest rates on savings accounts to attract more deposits from individuals and businesses. 3. **Borrowing from other banks or the central bank**: Banks can choose to borrow funds from other banks or the central bank to increase their cash reserves, depending on the interest rates offered. Each bank will select a strategy based on its financial health and market trends.

Step by step solution

Understand required reserves

Required reserves are the minimum amount of cash that banks are required to hold against their total deposits. Central banks, like the Federal Reserve in the US, establish these requirements to ensure that banks have enough cash to meet their customers' withdrawal requests and to maintain stability in the financial system. In this exercise, the required reserve ratio is initially 9%, meaning a bank must hold 9% of its total deposits in cash. The central bank has decided to increase it to 10%.

Calculate the new required reserve amount

Let's assume that a bank has \(D\) in deposits. Initially, with a 9% required reserve ratio, the bank must hold \(0.09D\) in reserves. With the new required reserve ratio of 10%, the bank has to hold \(0.10D\) in reserves. The bank, therefore, needs to come up with extra cash equal to \((0.10D - 0.09D)\), which is equal to \(0.01D\).

Option 1: Reducing loans and other investments

If the bank needs to come up with the additional cash equal to \(0.01D\), they can consider reducing loans and selling other investments. By decreasing its loan portfolio, the bank can free up funds that were previously tied up. Additionally, the bank can liquidate its investments in securities such as bonds or stocks to raise cash.

Option 2: Attracting more deposits

Another option for the bank to come up with the extra cash is to attract more deposits from individuals and businesses. The bank can offer new products or higher interest rates on savings accounts to attract new deposits, which will increase the total deposits, and hence, the available reserves.

Option 3: Borrowing from other banks or the central bank

Finally, banks can choose to borrow funds from other banks or the central bank to increase their cash reserves. Depending on the interest rates offered by these institutions, this may be a reasonable option to fulfill the new reserve requirements. In conclusion, if banks have to increase their required reserves from 9% to 10% of deposits, they need to come up with cash equal to 1% of their deposits. They have several options, including reducing loans and investments, attracting more deposits, or borrowing from other banks or the central bank, which will help them satisfy the new reserve requirements. Each bank will choose a specific strategy based on its current financial health and market trends.