8. The reserve requirement, open market operations, and the money supply Assume

Question

8. The reserve requirement, open market operations, and the money supply

Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $400. Determine the money multiplier and the money supply for each reserve requirement listed in the following table.

A higher reserve requirement is associated with a ________money supply.

Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to ______ __________worth of U.S. government bonds.

Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to _____to _______. Under these conditions, the Fed would need to __________ _____________worth of U.S. government bonds in order to increase the money supply by $200.

Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply.

The Fed cannot prevent banks from lending out required reserves.

The Fed cannot control the amount of money that households choose to hold as currency.

The Fed cannot control whether and to what extent banks hold excess reserves.

Reserve Requirement Simple Money Multiplier Money Supply (Percent) (Dollars) 20 10

Explanation / Answer

CASE 1

Reserve requirement (rr) = 20% or 0.20

Simple money multiplier = 1/rr = 1/0.20 = 5

The simple money multiplier is 5.

Money supply = Simple money multiplier * Total reserves

Money supply = 5 * $400 = $2,000

The money supply is $2,000.

CASE 2

Reserve requirement (rr) = 10% or 0.10

Simple money multiplier = 1/rr = 1/0.10 = 10

The simple money multiplier is 10.

Money supply = Simple money multiplier * Total reserves

Money supply = 10 * $400 = $4,000

The money supply is $4,000.

A higher reserve requirement is associated with a lower money supply.

If reserve requirement is 10% then simple money multiplier is (1/0.10) 10.

In order to increase money supply, Fed buys bonds.

Worth of US bonds bought by Fed = Increase in money supply/Simple money multiplier

Worth of US bonds bought by Fed = $200/10 = $20

So,

If the reserve requirement is 10%, the Fed will use open market operations to buy $20 worth of US government bonds.

Reserve ratio increases from 10% to 25%.

Simple money multiplier when reserve ratio is 25% is (1/0.25) 4.

So,

This increase in the reserve ratio causes the simple money multiplier to decrease to 4.

Worth of US bonds bought by Fed = Increase in money supply/Simple money multiplier

Worth of US bonds bought by Fed = $200/4 = $50

Under these conditions, the Fed would need to buy $50 worth of US government bonds in order to increase the money supply by $200.

In the real world, the Fed cannot precisely control the money supply because of the following two reasons -

1.The Fed cannot control the amount of money that households choose to hold as currency.

2. The Fed cannot control whether and to what extent banks hold excess reserves.

Hence, the correct answer is the option (2) and (3).

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