As the costs associated with deposit outflows ________, the bank’s willingness to hold excess reserves will ________.

Question

BlackTom AI · Accepted Answer

Higher costs from deposit outflows make liquidity shortfalls more expensive, so banks will raise their precautionary cash holdings — i.e., they become more willing to hold excess reserves.

1. Relevant knowledge points and concepts
- Reserves: cash held by banks at the central bank (required reserves) plus any reserves held above the required minimum (excess reserves).
- Liquidity risk and deposit outflows: unexpected withdrawals force a bank to obtain liquidity quickly (sell assets or borrow), often at a cost (fire-sale losses or high short-term borrowing rates).
- Trade-off: holding excess reserves yields low return (opportunity cost) but reduces the expected cost of responding to outflows.

2. Step-by-step reasoning
- Step 1: If the expected cost of running down reserves or raising emergency liquidity rises (because deposit outflows are costlier), the marginal benefit of holding an additional dollar of excess reserves rises — it lowers the probability and cost of emergency actions.
- Step 2: Banks compare the marginal benefit (reduced expected outflow cost) to the marginal cost (foregone interest from lending/investing that dollar).
- Step 3: As outflow costs increase, the marginal benefit curve shifts up, so the optimal reserve position involves more excess reserves.
- Step 4: Therefore, willingness to hold excess reserves increases.

3. Calculations / intermediate logic (conceptual)
- Let B = benefit from holding $1 excess reserve (reduction in expected outflow cost), C = opportunity cost (interest foregone). If B > C, hold the reserve. Increasing outflow costs raises B; when B increases above C for more units, the bank holds more excess reserves.

4. Why the correct answer is correct
Because higher outflow costs increase the value of liquidity insurance provided by excess reserves, banks respond by holding more of them to avoid expensive emergency measures.

5. Why the other options are incorrect
- (a) decrease; not be affected: contradicts the incentive effect — higher costs do affect behavior.
- (b) decrease; increase: the first part (“decrease”) is wrong — costs are said to decrease in (b), but the premise concerns costs increasing.
- (d) increase; decrease: this reverses the logical effect, implying higher outflow costs lead to less excess reserves, which ignores the precautionary motive.

Conclusion: As deposit outflow costs increase, a bank’s willingness to hold excess reserves increases; thus answer c. increase; increase is correct.

As the costs associated with deposit outflows , the bank’s willingness to hold excess reserves will .Single choice

Similar Questions

Expansionary fiscal policy in an open economy with a floating exchange rate will likely:

Contractionary monetary policy in an open economy with a floating exchange rate will likely:

Contractionary monetary policy in an open economy with a fixed exchange rate will likely ____ a trade surplus.

Which is expansionary monetary policy?

Which is contractionary fiscal policy?

Which is expansionary fiscal policy?

What would raise aggregate supply (AS)?

What would shift aggregate supply (AS) to the right?

More Practical Tools for Students Powered by AI Study Helper

Homework AI Solver

Stylized AI Paper Writer

Plagiarism Checker Assistant

Citation AI Academic Writing Tool

In-Class Translation Assistant

AI Note Generator

AI Quiz Answers

Past Exam Questions from University Test Bank

Smart Practice Assistant

Adaptive Practice

Making Your Study Simpler

As the costs associated with deposit outflows ________, the bank’s willingness to hold excess reserves will ________.Single choice