4 -2 Prepare a 2-3 page analysis by answering the questions below. Be sure to ci

Question

4 -2 Prepare a 2-3 page analysis by answering the questions below. Be sure to cite your references using APA format.

Assume that the Bank of Ecoville has the following balance sheet and the Fed has a 10% reserve requirement in place:

Balance Sheet for Ecoville International Bank

ASSETS                             LIABILITIES

Cash $33,000                    Demand Deposits $99,000

Loans 66,000

Required:

Now assume that the Fed lowers the reserve requirement to 8%.

1.What is the maximum amount of new loans that this bank can make?

2.Assume that the bank makes these loans. What will the new balance sheet look like?

3.By how much has the money supply increased or decreased?

4.If the money multiplier is 5, how much money will ultimately be created by this event?

5.If the Fed wanted to implement a contractionary monetary policy using reserve requirement, how would that work?

Explanation / Answer

Assume that the Fed lowers the reserve requirement to 8%. What is the maximum amount of new loans that this bank can make?

The bank is only required to keep 10% of the demand deposits as reserves. 10% of $99000 is $9900. The bank can therefore make loans up to $99,000 - 9900 = $89,100. It has actually made loans worth $66,000.

So even with no change in the required reserve ratios the bank can still make additional loans worth $23,100.

If the Fed reduces the required reserve ratio to 8%, the bank is now required to keep 8% of $99,000, or $7920. The bank can then make loans worth $99,000 - 7920 =$91,080.

The bank has already made actual loans worth $66,000 so it can further loan out $91,080-66,000 = $25,080.

Assume that the bank makes these loans. What will the new balance sheet look like?

If they made these loans, the balance sheet would look like this:

Assets
Cash: $7,920
Loans: $91,080

Liabilities
Demand Deposits: $99,000

By how much has the money supply increased or decreased?

If the bank actually loans out as much as allowed, then the initial increase in money supply is $25,080.

The final increase when all rounds have been completed will be determined by the money multiplier that is given by 1/r, where r is the required reserve ratio.

Given that r is 8%, the multiplier is 1/0.08 = 12.5. Hence, the increase in money supply is 12.5 x 25,080= $313,500.

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