1. Angus bank holds no excess reserves but complies with the reserve requirement

Question

1. Angus bank holds no excess reserves but complies with the reserve requirement. The required reserves ratio is 9% and reserves are currently $27 million. Determine the amount of deposits, the reserve shortage created by a deposit outflow of $5 million, and the cost of the reserve shortage if Angus Bank borrows in the federal funds market, assuming the federal funds rate is 0.25%.

2. Excess reserves acta s insurance against deposit outflows. Suppose that on a yearly basis Malcom Bank holds $12 million in excess reserves and $88 million in required reserves. Suppose that Malcom Bank can earn 3.5% on its loans and that the interest paid on total reserves is 0.2%. What would be the cost of the insurance policy?

Explanation / Answer

Angus Bank Reserve Ratio 9% Current Required Reserve 27 million Reserve is calcuated on amount of deposits Deposits=($27/9%) 300 million Deposits Outflow= $5 million Remaining Deposits=($300-$5) 295 million Current Required Reserve after outfow of deposits=($27-$5) 22 million Shortage of Reserve=($22-$295*9%) -4.55 million Angus Bank are required to borrow ($4.55) Cost of borrowings=($4.55*.25%) 0.011375 Cost of borrowings in millions=(.11375*1000000) 11375 Malcom Bank Excess Reserve 12 million Interest earns on loans 3.50% Interest paid on total reserves 0.20% Excess reserve acts as insurance against deposits outflow so cost of insurance policy is equals to interest income foregone -Interest Paid on excess reserve=($12*3.5%)=($12*.2%) 0.40 million Yearly cost of holding amount in excess of reserve or cost of insurance policy= $ 400,000.00

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