Assume that the banking system has total reserves of $100 million. Assume also t

Question

Assume that the banking system has total reserves of $100 million. Assume also that the reserve requirement for checking deposits is 10 percent and that banks do not hold any excess reserves. There is also no currency held by households.

a) What is the money multiplier? What is the money supply?

b) If the FED raises required reserves to 20 percent of deposits, what are the change in reserves and the change in money supply?

c) Now suppose the FED lowers the requirement to from 10 percent to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

d) If the FED sells $1 million of government bonds, what is the effect on the economy’s reserves and money supply? Use 10 percent required reserve ratio.

e) If the FED buys $5 million of government bonds, what is the effect on the economy’s reserves and money supply? Use 10 percent required reserve ratio.

Explanation / Answer

a. With banks holding only required reserves of 10%, the money multiplier is 1/.10 = 10. Because reserves are $100 billion, the money supply is 10 x $100 billion = $1,000 billion.

b. If the required reserve ratio is raised to 20%, the money multiplier declines to 1/.20 = 5. With reserves of $100 billion, the money supply would decline to $500 billion, a decline of $500 billion. Reserves would be unchanged.

c. Banks might wish to hold excess reserves if they need to hold the reserves for their day-to-day operations, such as paying other banks for customers' transactions, making change, cashing paychecks, and so on. If banks increase excess reserves such that there is no overall change in the total reserve ratio, then the money multiplier does not change and there is no effect on the money supply.

d. With a required reserve ratio of 10% and no excess reserves, the money multiplier is 1/.10 = 10. If the Fed sells $1 million of bonds, reserves will decline by $1 million and the money supply will contract by 10 x $1 million = $10 million.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.