Suppose the current money supply is $20,000. The reserve requirement is 0.10. Th

Question

Suppose the current money supply is $20,000. The reserve requirement is 0.10. The Fed wants to decrease the money supply by $1000. Assume that banks do not hold excess reserves and individuals hold no currency. Determine the following:

a. the money multiplier

b. the monetary base

c. the amount by which the Fed must change the reserve requirement to achieve the stated desired change in the money supply. (What should be the new reserve requirement ratio?)

d. If the Fed decides to use an open market operations tool instead, would it have to buy or sell bonds to achieve the stated desired change in the money supply, and by how much would it need to buy or sell bonds?

Explanation / Answer

(a) Money multiplier (MM) = 1 / Reserve ratio = 1 / 0.1 = 10

(b) Monetary base = Money supply / MM = $20,000 / 10 = $2,000

(c) New level of money supply = $20,000 - $1,000 = $19,000

Monetary base remaining unchanged,

$19,000 / MM = $2,000

MM = 9.5

1 / Reserve ratio = 9.5

Reserve ratio = 1/9.5 = 0.1053 = 10.53%

(d) For an equivalent open market operations, Fed has to sell bonds in open market to lower money supply.

Required amount of bonds to be sold = $1,000 / MM = $1,000 / 10 = $100

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