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If banks are currently holding zero excess reserves and the Fed raises the...

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

Choose one answer.

a. Banks will have a reserve deficiency.   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

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The correct answer to this question is A.  All of the other answers would be consistent with a situation in which the Fed actually lowers the reserve requirement.

A reserve requirement requires banks to hold a certain percentage of all their deposits rather than loaning them out.  If the Fed raises this requirement, it is telling the banks they must keep more of the deposits and lend out less.  If the bank is told this at a time when it has no excess reserves, it will fall short of the new requirement.  For example, let us imagine the original reserve requirement was 10% and the bank had $1,000 in deposits.  It would have kept $100 in reserves (no excess reserves).  Now let's say the Fed raises the reserve requirement to 15%.  Now the bank needs to have $150 in reserves.  This means it has a reserve deficiency.


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