1. If the reserve requirement decreases, will the money multiplier increase or d
ID: 1160233 • Letter: 1
Question
1. If the reserve requirement decreases, will the money multiplier increase or decrease? How will this affect the amount of money created in the economy? Fully explain why this is so.
2. Is the purchasing of bonds an example of expansionary or contractionary monetary policy? How will this shift the Money Supply curve? Discuss the process that occurs from the purchasing of the bonds to the shift of the MS curve.
3. Explain why the following statement is true or false:
During an economic expansion if the government wishes to slow down economic growth it can raise the reserve requirement.
Explanation / Answer
(1) If reserve requirement decreases, money multiplier will increase. This is because
Money multiplier (MM) = 1 / Reserve Requirement (RR).
Therefore, as RR decreases (increases), MM increases (decreases).
An increase in MM will increase the amount of money created, because
Increase in Quantity of money (supplied) = Monetary base x MM.
When MM increases, increase in money supply is higher.
(2) Purchase of bonds is an expansionary monetary policy tool that will increase money supply, shifting money supply curve rightward. When central bank purchases bonds in open market, reserves increase in banking system, and ceteris paribus, banks increase credit lending. Increase in credit creation will lead to an increase in money supply which is higher than the initial amount of bond purchase, due to money multiplier effect.
(3) TRUE
Increase in reserve requirement will decrease excess reserves, lowering credit lending and decreasing money supply. A fall in money supply will increase interest rate, decreasing investment and consumption demand, which will lower aggregate demand and slow down the economy.
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