Suppose the banking system has vault cash of $1,000, deposits at the Fed of $2,0

Question

Suppose the banking system has vault cash of $1,000, deposits at the Fed of $2,000, and demand deposits of $10,000.

a. If the reserve requirement is 20 percent, what is the maximum potential increase in the money supply, given the bank's reserve position?

b. If the Feb now purchases $500 worth of government bonds from private bond dealers, what are the excess reserves of banking system? (Assume that the bond dealers deposit the $500 in demand deposits). How much can the baking system increase the money supply, given the new reserve position?

Explanation / Answer

Part a

Required Reserves = Rate of Reserve requirement * Demand Deposits = 20% * $ 10,000 = $ 2,000

Excess Reserves = Total Reserves - Required Reserves = (Vault Cash + Deposits at Fed) - Required Reserves = ($ 1,000 + $ 2,000) - $ 2,000 = $ 1,000

Assuming that there is no leakage of funds from the circular flow of income,

Potential increase in money supply = Excess Reserves/Reserve Requirements = $ 1,000/20% = $ 5,000

Part b

Now, with a purchase of $ 500 worth of government bonds, The demand deposits will increase from $ 10,000 to $ 10,500 while the Total Reserves of Fed will increase from $ 3,000 to $ 3,500

Required Reserves = Rate of Reserve requirement * Demand Deposits = 20% * $ 10,500 = $ 2,100

Excess Reserves = Total Reserves - Required Reserves = (Vault Cash + Deposits at Fed) - Required Reserves = ($ 1,000 + $ 2,500) - $ 2,100 = $ 1,400

Assuming that there is no leakage of funds from the circular flow of income,

Potential increase in money supply = Excess Reserves/Reserve Requirements = $ 1,400/20% = $ 7,000

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