What is the required reserve ratio?
10%
25%
40%
5%
Suppose that the Federal Reserve (the "Fed") sells $10 million of bonds to a bond dealer, who pays the Fed by writing a check against the funds in her checking account. What is the initial impact of this transaction?
Checkable deposits fall by $10 million, and the banking system's holdings of securities fall by $10 million.
The banking system's holdings of securities rise by $10 million, and the banking system's total reserves fall by $10 million.
Checkable deposits fall by $10 million, and the banking system's total reserves fall by $10 million.
The banking system's holdings of securities fall by $10 million, and the banking system's total reserves rise by $10 million.
As a result of the Fed's sale of $10 million of securities, checkable deposits in the banking system can potentially by as much as .
As a result of the Fed's sale of $10 million of securities, checkable deposits in the banking system can potentially decrease by as much as $40 million.
This is because of the required reserve ratio. The required reserve ratio is the percentage of deposits that banks are required to hold in reserve. If the required reserve ratio is 25%, then banks are required to hold 25% of their deposits as reserves. Therefore, for every $1 in deposits, banks are required to hold $0.25 in reserves.
In this case, if the Fed sells $10 million of securities to a bond dealer, the bond dealer pays the Fed with a check against her checking account. This check results in a decrease in checkable deposits in the banking system by $10 million.
However, the impact on checkable deposits can potentially be larger than $10 million. This is because banks can multiply the initial deposit through the process of fractional reserve banking. Banks are only required to hold a fraction of the deposits as reserves. The remaining amount can be loaned out or invested, which increases the money supply.
The potential decrease in checkable deposits can be calculated using the formula: ΔD = (Initial deposit) * (1/Required reserve ratio - 1)
In this case, the potential decrease in checkable deposits is: ΔD = $10 million * (1/0.25 - 1) = $10 million * (4 - 1) = $10 million * 3 = $30 million.
Therefore, checkable deposits in the banking system can potentially decrease by $30 million.