Suppose Bank reserves are 150, the Currency held by the non-bank public is 300,

Question

Suppose Bank reserves are 150, the Currency held by the non-bank public is 300, and banks' desired reserve ratio is 10%.

What is M, the Money supply?

What is the monetary base?

Now: Suppose the Fed beings a policy of paying interest on reserves. As a result, suppose banks increase their desired reserve ratio to 15%. (Why is it plausible that this number should increase?) Find what happens to the money supply if the Fed does nothing. What happends to Currency? Deposits? Bank Reserves? Explain qualitatively why this happens, i.e. why the money supply should change in the direction you found when the desired reserve ratio goes up. If the Fed wants to keep the money supply at its original level, find the amount of open market purchases or sales it will have to undertake to do so.

Explanation / Answer

Money supply = 1/required reserve*Bank Reserves = 1/0.1*150 = 1500

Monetary Base = Currency + Bank Reserves = 300 + 150 = 450

Find what happens to the money supply if the Fed does nothing. What happends to Currency? Deposits? Bank Reserves?

If /required reserve increaases to 15% , Then

Money Supply = 1/required reserve*Bank Reserves = 1/0.15*150 = 1000

So, Money supply decreases from 1500 to 1000

Currency remains same , Bank excess reserves decreases

why the money supply should change in the direction you found when the desired reserve ratio goes up

Money supply decreased because money that doesn't have to be reserved at a bank is money that can be used to make new loans. Money that can be loaned out is money that can filter through the economy and multiply through a process of multiple deposit expansion as businesses and consumers borrow money to invest. That means increase in the reserve ratio will decrease the multiplier effect, and that decreases the money supply.

If the Fed wants to keep the money supply at its original level, find the amount of open market purchases or sales it will have to undertake to do so

Amount of open Market Operations = Change in money Supply = 1500 - 1000 = 500

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