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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

01

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.
02

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.
03

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.

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Most popular questions from this chapter

The Fed has announced a new, lower target for the federal funds rate; in other words, the Fed wants to lower the federal funds rate from its present level. What does setting a lower target for the federal funds rate have to do with open market operations?

Suppose you read in the newspaper that all last week the Fed conducted open market purchases and that on Tuesday of last week it lowered the discount rate. What would you say the Fed is trying to do?

Suppose the Fed raises the required reserve ratio, a move that is normally thought to reduce the money supply. However, banks find themselves with a reserve deficiency after the required reserve ratio is increased and are likely to react by requesting a loan from the Fed. Does this action prevent the money supply from contracting as predicted? Explain your answer.

What does it mean to say that the Fed serves as the lender of last resort?

Explain how market forces would determine the money supply under free banking.
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