Q4. Why does the Federal Reserve req... [FREE SOLUTION] (2024)

Chapter 15: Q4. (page 318)

Why does the Federal Reserve require commercial banks to have reserves? Explain why reserves are an asset to commercial banks but a liability to the Federal Reserve Banks. What are excess reserves? How do you calculate the amount of excess reserves held by the bank? What is the significance of excess reserve?

Short Answer

Expert verified

Federal Reserve requires commercial banks to have reserves against their checkable deposits.

Reserves help banks earn interest, so it is an asset for commercial banks.

Reserves are a liability as they require interest payment from Federal Reserve Bank.

Excess reserves are additional reserves over and above the required reserves.

It can be calculated by finding the difference between the actual reserves and the required reserves.

Interest is paid on these required reserves and also the excess reserves banks held at the Fed. Keeping reserves high helps to maintain trust with the public.

Step by step solution

Reason why reserves are required

Reserves are required to meet customers' expected or sudden demand for money. This is to avoid default risk and stop people from panicking. The aim is to meet the demand for withdrawals which ensures the public of continuous flow of banking services.

Reason why reserves can be asset and liability both

Reserves are an asset to commercial banks because commercial banks earn interest on the required reserves held with the fed. Commercial banks can also use the excess reserves to lend out loans that also earn interest.

For the Federal Reserve Banks, reserves are a liability because interest is paid to commercial banks for the amount of reserves held with the fed.

Meaning and calculation of excess reserves

Amount over above the required reserve kept by the banks is known as excess reserves.

The difference between total deposits with the commercial bank and the required reserve ratio is the Excess Reserves. Say deposits with a commercial bank are $1000, and the required reserve ratio is 10%.

Therefore, Excess reserve = $1000-$(1000x10/100) = 1000-100=$900.

Significance of excess reserves

The excess reserves are part of the total deposit of commercial banks they can safely lend. Excess reserves help commercial banks create credit and earn interest on advanced loans. Credit creation increases the total money supply.