Money Creation When Banks Hold Excess Reserves
A banking system has $500 million in total reserves and $2,000 million in checkable deposits. The required reserve ratio is 10%. Banks are currently holding no excess reserves because loan demand has been strong, but a sharp recession causes banks to become cautious: they decide to hold an additional 5% of deposits as excess reserves and stop lending aggressively. Meanwhile, the Federal Reserve purchases $40 million in government securities from banks. The public holds no currency.
1. Before the recession (no excess reserves), what was the money multiplier and the maximum possible change in the money supply from the Fed's $40 million purchase?
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With no excess reserves and no currency holdings, the simple money multiplier = 1/rr = 1/0.10 = 10.
Maximum ΔMS = $40M × 10 = $400M.
Check: initial reserves $500M support $500M/0.10 = $5,000M in deposits, but actual deposits are $2,000M - wait, that would imply excess reserves already exist. Recomputing: required reserves = 0.10 × $2,000M = $200M; actual reserves $500M imply $300M excess. The setup's claim of no excess reserves is inconsistent with these numbers, so treat the $40M purchase independently: the multiplier of 10 applies to new reserves, giving a maximum expansion of $400M assuming banks lend out all new reserves.
2. After banks adopt the 5% excess reserve policy, recompute the effective money multiplier and the money-creating potential of the same $40 million purchase. Explain the economic meaning of the difference.
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Effective reserve ratio = required 10% + excess 5% = 15% = 0.15.
Effective multiplier = 1/0.15 ≈ 6.67.
ΔMS = $40M × 6.67 ≈ $266.7M.
The difference ($400M vs. $266.7M) shows that when banks hold excess reserves, each dollar of reserves supports fewer deposits because a larger fraction is parked rather than lent. In a recession, banks' precautionary demand for reserves weakens the transmission of monetary policy - the Fed injects reserves but they sit idle, so the money supply expands less than the simple model predicts. This is a key reason quantitative easing can be less stimulative than the multiplier suggests.
3. Explain how this change in bank behavior affects the money supply process even if the Fed does nothing, and connect it to the concept of the money multiplier being endogenous.
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If banks voluntarily raise their excess reserve ratio without any Fed action, the effective multiplier falls (from 10 to 6.67), so the same monetary base supports a smaller money supply - the money supply contracts through the banking system's own choices. This illustrates that the money multiplier is not a fixed constant set by the Fed; it depends on bank reserve behavior and the public's currency holdings. The Fed controls the monetary base, but the money supply is jointly determined by the base, the reserve ratio, and the currency-deposit ratio - making the multiplier endogenous to economic conditions.