Question

If banks are currently holding zero excess reserves and the Fed raises the required-reserve ratio, which of the following will happen?

Select one:

a. Banks will have a reserve deficiency and will look to sell assets or securities to raise cash (reserves).

b. Banks will have positive excess reserves.

c. Banks will begin to extend more loans.

d. Banks will begin to extend more credit.

e. b and d

Answer 1

The correct answer is Option (A) Banks will have a reserve deficiency and will look to sell assets or securities to raise cash (reserves)

Explanation -

Under the modern fractional reserve banking system, banks can have only a fraction of reserves as deposits and the remaining amount can be lent to consumers and businesses. Therefore, when banks have zero excess reserves and the reserve requirement increases, the banks need to raise cash to meet the new reserve requirement.

Just as an example -

A bank has $100 deposit and under a 10% reserve requirement system, the bank keeps $10 as reserves. The remaining $90 is loaned out by the bank. Now the reserve requirement increases to 15%. This implies that for the same deposit of $100, the bank need to have $15 as reserves. Since the bank has only $10 in reserves, it needs to sells assets or securities to raise an additional $5 to meet the reserve requirement.