Consider the following information about the banking system: Reserves = $500 bil

Question

Consider the following information about the banking system:

Reserves = $500 billion

Currency = $400 billion

Required Reserves = $80 billion

Reserve Ration = .1%

A) What is the value of deposits in the banking system?

B) What is the value of the money supply?

C) What is the value of the money multiplier?

D) If the Fed wishes to have the value of the money supply in the economy at the initial level ($5.4 trillion), how should it respond? Explain.

E) How much in government bonds should the Fed sell or buy?

Explanation / Answer

(A) Value of deposits ($ Billion) = Required Reserves / Reserves ratio (rr) = 80 / 0.1% = 80 / 0.001 = 80,000

(B) Money supply ($ Billion) = Currency + Deposits = 400 + 80,000 = 80,400

(C)

Currency deposits ratio (c) = Currency / Deposits = $400 billion / $80,000 billion = 0.005

Money multiplier = (1 + c) / (c + rr) = (1 + 0.005) / (0.005 + 0.001) = 1.005 / 0.006 = 167.5

(D)

Current level of money supply = $80,400 billion

Required level of money supply = $5.4 trillion = $5,400 billion

Fed has to decrease money supply by $(80,400 - 5,400) billion = $75,000 billion using contractionary monetary policy (using open market sale of government bonds and/or by raising discount rate and/or by raising reserves ratio).

(E)

Required amount of bonds to be sold by Fed = $75,000 billion / 167.5 = $447.76 billion

NOTE: You may cross-check the value of Reserves ratio you have provided (= .1%), which is too small to be valid in real world, which has resulted in an excessively high money multiplier. I've answered on the basis of the number of you have provided.

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