Suppose That Serendipity Bank Has Excess Reserves Of $8,000 And Checkable Deposits Of $150,000.

In this article, we will discuss what a bank account is, how banks create money in accounts, and why serendipity banks have excess reserves.

A bank account is an account that a bank provides to its customers. These accounts can be savings accounts, checking accounts, or even credit card accounts.

Banks create money in accounts when they offer interest-bearing products and loan out money that they receive as deposits. When a customer receives a loan from the bank, they have money in their account that they can use.

Serendipity banks have excess reserves because of regulatory requirements on how much cash a bank must hold compared to the amount of loans and investments it has. If a bank does not meet these requirements, then it must go to the central bank to get more cash.

Calculate the bank’s excess reserves

Now let’s suppose that Serendipity Bank has excess reserves of $8,000 and checkable deposits of $150,000.

Excess reserves are the amount by which a bank holds deposits at the Federal Reserve in accounts called deposit accounts of account type A. These accounts earn no interest, so there is little incentive to hold them unless required to do so.

To calculate the amount of excess reserves, subtract the required reserve ratio from the total deposit liabilities. Then divide that number by the total checkable deposits: ($8,000 – $7,500) / $150,000 = 1%

Since Serendipity Bank only has 1% excess reserves, it can lend out most of its money without worrying about whether it will be able to re-deposit it at the Federal Reserve.

What is the effective federal funds rate?

The effective federal funds rate is the interest rate at which banks can either borrow or lend funds to each other overnight. It is determined by the Federal Reserve as part of its monetary policy operations.

The Fed sets a target for the effective federal funds rate and tries to steer market interest rates toward that target. When the Fed wants to tighten monetary policy, it hikes the target for the effective federal funds rate.

When it wants to ease policy, it lowers the target for the effective federal funds rate. The hope is that banking institutions will take notice and adjust their own lending rates accordingly.

The effective federal funds rate is very close to, but slightly lower than, the Fed’s target for its conventional benchmark lending rate, the federal fund’s discount rate. This is because banks can earn a very small amount of interest on overnight loans.

What is the bank’s opportunity cost of holding excess reserves?

The opportunity cost of holding excess reserves is the return the bank could have earned by investing the reserves in a time deposit.

For example, Suppose That Serendipity Bank could earn a 1% annual return on a one-year time deposit. Because one year’s worth of daily average reserve balance equals $8,000, the bank could invest up to that amount in a time deposit.

Therefore, its opportunity cost would be 1% × $8,000 = $80 per year. Because it holds excess reserves of $8,000, it pays an opportunity cost of $80 per year.

Suppose That Serendipity Bank decides to invest its excess reserves in a one-year time deposit with an annual return of 1%.

What would happen to the bank’s excess reserves if interest rates increased?

In this scenario, let’s assume that interest rates increase by 1%. This increase in the federal funds rate would cause the bank to make an extra $1 in interest income on each of its savings accounts.

Because the bank has $8,000 in excess reserves, it would earn $8 in interest income. The total income for the bank would remain at $100.

Since the bank’s checkable deposits are $150,000, it would incur a loss of 1% on all of its deposits. The total cost of operating the bank would decrease by $1,500.

Because there was no change in the volume of banking activities (the number of savings accounts and checkable deposits), net earnings would decrease by $1,500 ($1,500 -$1).