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 0.50% on its holdings of reserves and that Bank of America can earn 7% on its loans and other investments.
a. 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.
b. Is the opportunity cost to banks of reserve requirements likely to be higher during a period of high inflation or during a period of low inflation? Briefly explain.