Question

Suppose that Bank of America pays a 2% annual interest rate on checking account balances while having to meet a reserve requirement of 10%. Assume that the Fed pays Bank of America an interest rate of 0.2% on its holdings of reserves and that Bank of America can earn 6% on its loans and other investments. How do reserve requirements affect the amount that Bank of America can earn on $1,000 in checking account deposits? Ignore any costs Bank of America incurs on the deposits other than the interest it pays to depositors. The 10% reserve requirement reduces the amount Bank of America can earn on $1,000 by __________

Answer 1

Answer:

The 10% reserve requirement reduces the amount Bank of America can earn on $1,000 by $5.80

Explanation:

With a 10% reserve requirement, Bank of America must hold $100 of a $1000 checking account deposit in reserves with the Fed on which it receives an interest rate of 2%. The bank can invest remaining $900. So the bank will earn

$900*.06 + 100*.002=$54.2

If the bank did not need to hold reserves against the deposit, it would earn $1000*.06=$60. So the reserve requirement is reducing Bank of America's return by $5.80

The 10% reserve requirement reduces the amount Bank of America can earn on $1000 by $5.80.