The Monetary System

Question 1: What are reserve requirements? Why State Bank of Pakistan use reserve requirements to control the money supply? Reserve requirements are regulations on the minimum amount of reserves that banks must hold against deposits. An increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply. When using reserve requirements, the central bank is not so completely in control. Question 2: What is meant by the following terms: capital adequacy ratio, liquidity ratio and cash reserve ratio? How does a decrease in the OCR affect the cash reserve ratio, and why? The capital adequacy ratio (CAR) is the ratio of a banks capital stock that is easily exchangeable to cash to its total risk weighted financial assets. The liquidity ratio (LR) the ratio of settlement cash to banks assets that can be used as collateral. The reserve ratio is the ratio of the amount of cash reserves that banks must hold against deposits. If the SBP decreases the CMR, the banks will lower their cash-to-deposit ratio, and the money multiplier will work such that the money supply will increase at any given level of interest. This is because a lower CMR decreases the opportunity cost of cash reserves and hence the banks will lower their cash-to-deposits ratio.

Question 3: National Bank (NB) holds $250 million in deposits and maintains a reserve ratio of 10%. a) Show a T-account for NB b) Now suppose that NBs largest depositor withdraws $10 million in cash from her account. If NB decides to restore its reserve ratio by reducing the amounts of loans outstanding, show its new T-account. c) Explain what effect NBs action will have on other banks. d) Why might it be difficult for NB to take the action described in part (b)? Discuss another way for NB to return to its original reserve ratio. a) Here is NB's T-account: National Bank Assets Reserves Loans $25 million $225million Deposits Liabilities $250 million

b) When NB's largest depositor withdraws $10 million in cash and NB reduces its loans outstanding to maintain the same reserve ratio, its T-account is now:

National Bank Assets Reserves Loans $24 million $216 million Deposits Liabilities $240 million

c) Since NB is cutting back on its loans, other banks will find themselves short of reserves and they may also cut back on their loans as well. d) NB may find it difficult to cut back on its loans immediately, since it cannot force people to pay off loans. Instead, it can stop making new loans. But for a time it might find itself with more loans than it wants. It could try to attract additional deposits to get additional reserves, or borrow from another bank or from the SBP.

Question 4: The State Bank buys $20 million worth of government bonds from a selected number of registered banks which are registered for such open market operations. If the optimal reserve ratio is 5%, what is the largest possible increase in the money supply for any given interest rate that could result? What is the smallest possible increase? Explain.

With a required reserve ratio of 5 per cent, the money multiplier could be as high as 1/.05 = 20, if banks hold no excess reserves and people do not keep some additional currency. So the maximum increase in the money supply from a $20 million openmarket purchase is $400 million. The smallest possible increase is $20 million if all of the money is held by banks as excess reserves.