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When banks take money in from depositors, they do not keep all of the money in their vaults. Instead, they lend most of it out. However, they also do not lend all of the money. Banks are typically required to hold a certain amount in reserve. The reason for this is that banks need to have money on hand to satisfy depositors who wish to make withdrawals. Therefore, banks always hold some reserves. Banks can hold the bare minimum that is required or they can hold excess reserves in addition to what is required.
In the question given here, the bank has no excess reserves. It is only holding required reserves. It has $1 million in deposits and $40,000 in reserves. To find the reserve ratio, all we have to do is divide the reserves by the total deposits. When we do this, we find that the reserve ratio is only 4%. Thus, the bank’s reserve ratio in this case is 4%.
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