Suppose that currency in circulation is $600 billion, the amount of checkable de

Question

Suppose that currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, and excess reserves are $15 billion. The required reserve ratio on checkable deposits is 10%.

(a) Calculate the money supply, the currency deposit ratio, the excess reserve deposit ratio, and the money multiplier.

(b) Suppose that the central bank conducts an unusually large open-market purchase of bonds held by banks in the amount of $1,400 billion due to a sharp contraction in the economy. Assuming that the ratios you calculated in part (a) do not change, what do you predict will be the effect on the money supply? Also, what will happen to currency in circulation and checkable deposits in the banking system after the open-market purchase has run its course?

(c) Suppose that the central bank conducts the same open-market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain unchanged, what happens to the amount of excess reserves, the excess reserve deposit ratio, the money supply, and the money multiplier?

(d) During the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, but at the same time, very little lending from banks to the nonbank public occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this relate to your answer to part (c)?

Explanation / Answer

We are given that currency in circulation C = $600 billion, the amount of checkable deposits D = $900 billion, and excess reserves ER = $15 billion. The required reserve ratio on checkable deposits RR-D = 10%.

(a) Calculate the money supply, the currency deposit ratio, the excess reserve deposit ratio, and the money multiplier.

Find that RR-D = (1/10). ER-D = 15/900 = (1/60), C-D = 600/900 = (2/3). Monetary base = C + RR + ER = 600 + 90 + 15 = $715. Money supply = C + D = 600 + 900 = 1500 billion.

Money multiplier mm = (1 + (2/3))/((1/10) + (1/60) + (2/3)) = 2.218

(b) Suppose that the central bank conducts an unusually large open-market purchase of bonds held by banks in the amount of $1,400 billion due to a sharp contraction in the economy. This increases monetary base by $1400 and so money supply is increased by 2.218 x 1400 = 2979 billion. New money supply is 4479 billion, C + D also increases from 1500 to 4479.

(c) Suppose that the central bank conducts the same open-market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain unchanged. This implies that ER-D ratio is now (15 + 1400)/900 = 1.5722. Money multiplier is mm = (1 + (2/3))/((1/10) + (1.57) + (2/3)) = 0.713 and so money supply will remain 900.

(d) During the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, but at the same time, very little lending from banks to the nonbank public occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. We have shown that as banks lend less reserves, less money is creased as money multiplier becomes smaller. This is what happened in 2008 when banks were not lending the excess reserves.

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