If a bank becomes worried about the future, it may decide to increase the level

Question

If a bank becomes worried about the future, it may decide to increase the level of excess reserves it holds in hopes of avoiding a trip to the Fed's discount window.

A. If a large number of banks increase their excess reserve ratio, or the share of total deposits held in excess reserve, what effect will this have on the money supply? Explain your answer. (4 points)

B. If a large number of banks decrease their excess reserve ratio, what effect will this have on the money supply? Explain your answer. (4 points)

C. Explain why bank runs are a particularly important problem under fractional reserve systems and the role that the FDIC plays in preventing them. (8 points)

Explanation / Answer

a)

Excess reserves are those reserves of money with the banks which they use to loan out to lenders and thus increase money supply.

If the banks decide to increase their excess reserve ratio, the amount which can be loaned out in the economy will increase, thereby increasing the money supply in the economy.

b)

If the banks decide to decrease their excess reserve ratio, the amount which can be loaned out in the economy will decrease, thereby decreasing the money supply in the economy.

c)

Bank runs occur when the public gets worried about the safety of their money with the banks and thus run to the banks to take back their money. Banks run on the principle of give and take. They take money from a few lenders and loan out to a few investors. It is like a continous cycle. When only a few lenders demand back their money, banks are able to easily withdraw some of its money from its reserves and give them back without disturbing their cycle. However, when all of its lenders come to withdraw all of their money, it becomes a situation of panic with the banks, who find themselves unable to ask back the money they have loaned to their borrowers, and thus goes bankrupt.

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