Excess Cash Reserves (a) Excess cash reserves are the amounts that the banks hold in excess of the reserve requirements. These funds come from the deposits that people make with the banks and are later used up to advance credit to the borrowers. (b) Banks usually, are required to maintain a certain amount of their reserves with the central bank of the particular economy. This fraction is known as reserve requirements and the portion left over after depositing this amount with the central bank is known as excess reserves. Generally, banks lend out of these excess reserve amounts which initiate the process of credit creation.
Since it is necessary for one bank at least to possess a certain amount of excess reserves for the creation of credit, this fraction of reserves is often known as “the stuff from which the banks create loans”. (c) Central banks generally manage the flow of excess reserves left with the banks through adjusting the rate of reserve requirements. A higher cash reserve ratio would mean a lower availability of excess reserves to the banks and hence, the lending powers of the banks fall.
Similarly, the volume of liquidity rises when the central bank allows the banks to hold a higher amount as excess reserves. This is a monetary policy instrument which the central banks employ to adjust price stability in a nation. Answer to Question 2 (a) The Federal Reserve must have raised the cash reserve ratio that determines the amount of money that the commercial banks need to maintain with the central banks of their host nations. (b) Appreciation of the cash reserve ratio would mean a reduction in the availability of excess reserves with any commercial bank.
Since the change happens overnight, the banks can in no way restrict the demand for loans in the market. Given the demand for loans and a reduced amount of excess reserves with them, the banks turn to their respective central banks to bail them out of the situation. Assuming that the situation is similar with every bank, demand for loans increase with the central banks and this is when they increase the discount rate, i.e. , the federal funds rate.
Answer to Question 3 (a) The process of credit creation is initiated only if the amount being lent out by the first bank is circulated in an economy. Instead of being circulated, if it is destroyed at the very first place, there will be no credit creation. In addition, the amount being borrowed would be lost thus creating a negative impact upon the supply of money in the economy. Hence, in the present case, the change in aggregate money supply in the nation will be equal to US$ -2000.
(b) In case that new money worth of US$ 10,000 is borrowed by Jane and the required reserve ratio is equal to 15%, the maximum change in money supply in the economy can be deduced with the help of the following formula, Change in Money Supply = Monetary Base x Here, monetary base = US$ 10,000 and R = Reserve requirement = 15% = 0.15 Hence, total change in money supply = 10,000 x = (US$) 66666.67. (c) Two reasons why the money supply might not change by the maximum amount being deduced above are – If one of the borrowers in line are found to consume a certain portion of the amount borrowed rather than saving the whole amount with another bank.
If the central bank meanwhile, increases the reserve requirement, the value of money multiplier (1/R) falls so that money supply does not undergo maximum change. (d) Required reserve amount = Actual reserves – Excess reserves. Hence, in the present case, required reserves = US$ (1,000 – 100) = US$ 900. Answer to Question 4 Fractional reserve banking system is an unstable one since under it, the bank often lends out an amount which if often unsupported by the availability of actual cash.
It is more like the circulation of fake or counterfeit money, i.e. , something which is not backed by any physical existence. Hence, in case that more than the anticipated number of bank customers arrive to withdraw their money, the banks would be at a loss. Two ways in which the government regulation has facilitated fractional banking system are – (i) No bank is prepared to risk their reputation through participating in fractional reserve banking system unless they are insured by the government, which usually stands as the last resort.
The national government of a nation, hence, must stand as the guarantor of the bank’s assets to help realize the fractional banking system. Such an assurance by virtue of government regulations is made by means of providing notes approved by the government to the borrowers; these notes are often referred to as fiat money. (ii) Moreover, the banks in their urgency to meet excess demands for withdrawals have the liberty to raise them through selling securities to the government via the central bank, so as to get an instant access to money.
Hence government regulation has made it possible for banks to withdraw money at a short notice to meet consumer demand. A free market is characterized by the influence of market forces. Hence, in a free market system, with no external government support, that also is characterized by unavailability of government fiat money, Federal Reserve and Federal Deposit, the banks would rarely risk to keep a small amount of reserves with them, since that would expose them to a loss of reputation in case demand for withdrawals increase.
Thus, a completely free market cannot contain fractional reserve banking system in it. Through its support, the government thus, helps to increase the availability of money in an economy, since the banks need not maintain an immense volume of reserves to meet demands for withdrawals. With the support of the government however, they are successful in advancing credits which are non-existent physically. Hence, banks usually have no limit over the supply of money and a problem similar to that of seigniorage crops up.
This in turn, leads to an increase in liquidity in the economy and hence causes inflation. Since the commercial banks cannot go ahead with such a program unless there is government support, the latter could be regarded as an entity which contributes indirectly towards causing inflation. Bibliography Mankiw, N. G. (2008). Principles of Economics (5th Edition). New York: Cengage Learning.