Question 1 (30%) The Economy of Elmedyn contains 3000 $1 bills. a. If people hol

Question

Question 1 (30%)

The Economy of Elmedyn contains 3000 $1 bills.

a. If people hold all money as currency, what is the quantity of money?

b. If people hold all money as demand deposits and banks maintain 100 percent reserves, what is the quantity of money?

c. If people hold equal amounts of currency and demand deposits and banks maintain 100 percent reserves, what is the quantity of money?

d. If people hold all money as demand deposits and banks maintain a reserve ratio of 10 percent, what is the quantity of money?

Explanation / Answer

a) If all money is held as currency then the quantity of money will be $3,000.

b) If the money is deposited in banks and the banks maintain 100% reserves then the money multiplier will not come into effect as all the money is being held as reserves. Therefore, the quantity of money will be $3,000.

c) Amount of Currency = 3000 / 2 = $1,500

Amount of Deposits = 3000 / 2 = $1,500

Since the banks maintain 100% reserves then the money multiplier will not come into effect as the $1,500 deposited in the banks is being held as reserves.

Therefore, the quantity of money will be $3,000 (1,500 + 1,500).

d) Amount of Deposits = $3,000

Reserve Ratio (RR) = 10% = 0.1

Money Multiplier (m) = 1 / r

m = 1 / 0.1

m = 10

Quantity of Money (M) = Deposits * Money Multiplier

M = 3000 * 10

M = $30,000

When people depost money in the banks, bank maintains the required reserve of deposits with them and lends out the rest as loans. The money is transferred into a new bank account and on those reserves the bank maintains the reserve ratio and lends the remaining as loans again. This cycle continues and therefore banks are able to increases the money supply in the economy. Due to this process of money creation the quantity of money in this case is $30,000.

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