Because the required reserve ratio is 20%, the $1,500,000 withdrawal increases /

Question

Because the required reserve ratio is 20%, the $1,500,000 withdrawal increases / decreases First Main Street Bank's required reserves by $600,000 / $1,500,000 / $300,000. In order to maintain the required reserve ratio, First Main Street Bank now must decrease / increase its reserves by $1,200,000 / $900,000 / $1,500,000 / $0. One possible way to do this is to decrease / increase its outstanding loans.

Assume this process continues, with each successive loan being repaid using a checking account and banks using repayments to replenish their reserves without issuing any new loans. Under these assumptions, the initial destruction of $1,500,000 by the Fed results in an overall decrease of $6,000,000 / $750,000 / $7,500,000 / $300,000 in checkable deposits.

Suppose First Main Street Bank, Second Republic Bank, and Third Fidelity Bank all have zero excess reserves. The required reserve ratio is 20% Paolo, a client of First Main Street Bank, purchases $1,500,000 of Treasury bills in an open market sale undertaken by the Fed. Upon receipt of Paolo's check, the Fed subtracts $1,500,000 from First Main Street Bank's Federal Reserve account, thereby extinguishing the money. Complete the following table to reflect any changes in First Main Street Bank's balance sheet (before the bank makes any new loans). First Main Street Bank's Balance Sheet Assets Liabilities Because the required reserve ratio is 20%, the $1,500,000 withdrawal First Main Street Bank's required reserves by . In order to maintain the required reserve ratio, First Main Street Bank now must its reserves by One possible way to do this is to_its outstanding loans by Second Republic Bank Now suppose Lucia repays her loan of $1,200,000 to First Main Street Bank by writing a check issued by Second Republic Bank. First Main Street Bank uses funds from a loan repayment to increase its reserves instead of making new loans. Second Republic Bank then replenishes its reserves by using the funds from loan repayments by Kenji, who writes a check issued by Third Fidelity Bank. Third Fidelity Bank then uses a loan repayment from Sharon to replenish its reserves instead of making new loans.

Explanation / Answer

(a) This will decrease Reserves (Asset side) by $1,500,000 and decrease Checkable deposits (Liability side) by $1,500,000.

(b) Required reserve being 20%, the withdrawal will decrease required reserves by $300,000 (= $1,500,000 x 20%).

(c) To maintain required reserves, Bank must increase reserves by $1,500,000. A possible way to do this is to decrease outstanding loans.

(d)

(e) Overall decrease in checkable deposits = $7,500,000 (= $1,500,000 / 0.2)

Decrease: Deposit Decrease: Required Reserve Decrease: Loan First Bank 1,500,000 300,000 1,200,000 Second bank 1,200,000 240,000 960,000 Third bank 960,000 192,000 768,000

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