Consider a model of money supply. Suppose that in 2008, monetary base B is $100

Question

Consider a model of money supply. Suppose that in 2008, monetary base B is $100 billion, the reserve-deposit ratio rr is 0.005, and the currency-deposit ratio cr is 0.07. Calculate money multiplier. Calculate money supply. What would have happened to the money supply if the currency-deposit ratio had risen but the reserve-deposit ratio had remained the same? Explain. What would have happened to the money supply if the reserve-deposit ratio had risen but the currency-deposit ratio had remained the same? Explain. Which of the two changes in (c) and (d) was more responsible for the fall in the money supply? and why?

Explanation / Answer

Answer : Monetary Base = $100

Reserve deposit ratio (rr) = 0.005

Currency deposits ratio (cr) = 0.07

a . m = (cr+1)/(cr+rr)

m = (0.07+1)/(0.07+0.005) = 1.07/0.075 = 14.2666

B. Money supply = Monetary Base * m

Money supply = $100 billion* 14.27 = $1427billion

C. Currency deposit ratio has been increased but reserve ratio remains same the money supply will decrease as a result an increase in the currency deposit ratio lead to a decrease in money multiplier . Now banks have fewer fund to create deposit therefore money multiplier decreases.

D. The increase in reserve deposit ratio will decrease the money multiplier the money supply will fall because banks have more reserve to maintain with bankas well as monetary base increases.

E. The increase in currency deposit ratio is more responsible for decrease in money supply because in the case of reserve ratio when it increases the fewer funds are available with bank but monetary base increases which result is less fall in money supply . As compared to currency deposit ratio people should deposit less amount of money in the bank as compared to earlier which shows that there is a fewer fund which decreases money supply.

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