When the Fed adds new reserves to the system, some of these new reserves find th

Question

When the Fed adds new reserves to the system, some of these new reserves find their way out of the country into foreign banks or foreign investment funds. In addition, some portion of these new reserves ends up in people's pockets and mattresses instead of bank vaults. These "leakages" reduce the money multiplier and sometimes make it difficult for the ages to control the money supply precisely. Explain why this is true. When the Fed adds new reserves to the system, some of these new reserves find their way out of the country into foreign banks or foreign investment funds. In addition, some portion of these new reserves ends up in people's pockets and mattresses instead of bank vaults. These "leakages" reduce the money multiplier and sometimes make it difficult for the ages to control the money supply precisely. Explain why this is true.

Explanation / Answer

Fed increases the new reserves in the system so that money multiplies and increases by larger proportion. Process of money multiplier is done by the commercial banks who take deposits from the public and after keeping a proportion of their deposit, lend the remaining amount. The proportion of deposits which banks keep with themselves in the form of reserves is known as required reserve ratio that helps the banks in case of any emergency or problem. Increase in reserve ratio decreases the money multiplier as more proportion of deposits are kept as reserve but when Fed wants to increase money supply then, it decreases the required reserve ratio. Lending by various banks from their deposits creates more money in the economy but when people save money with themselves without depositing in banks then, banks does not get more money from the public and due to this there are not able to create money with its potential. Similarly, when people invest their money in foreign markets then also deposits of domestic banks decreases as otherwise this amount will come into the banks. These leakages reduces the money multiplier effect in the economy and make it difficult for the ages to control the money supply.

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