Suppose the Federal Reserve increases the amount of reserves by $100 million and

Question

Suppose the Federal Reserve increases the amount of reserves by $100 million and the total money supply increases by $500 million.

a. What is the money multiplier?

b. Using the money multiplier from part a, how much will the total money supply increase by if the Federal Reserve increases the amount of reserves by $50 million?

     $ million

Suppose the Federal Reserve sets the reserve requirement at 15%, banks hold no excess reserves, and no additional currency is held.

a. What is the money multiplier?

     Instructions: Round your answer to 2 decimal places.

b. How much will the total money supply increase by if the Federal Reserve increases the amount of reserves by $200 million?

     $ million

c. When the Federal Reserve increases the reserve requirement, the money multiplier will (Click to select)increaseremain the samedecrease and an increase in reserves will have (Click to select)a smallerthe samea larger effect on the money supply.

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Explanation / Answer

Q1.

(a)

Increase in amount of reserves by Fed = $100 million

Increase in money supply = $500 million

Calculate Money multiplier -

Increase in money supply = Increase in reserves * Money multiplier

Rearranging the above formula -

Money multiplier = Increase in money supply/Increase in reserves

                        = $500 million/$100 million

                        = 5

The money multiplier is 5.

(b)

Increase in amount of reserves by Fed = $50 million

Money multiplier = 5

Calculate increase in money supply -

Increase in money supply = Increase in amount of reserves by Fed * Money multiplier

                                      = $50 million * 5

                                      = $250 million

The Total money supply will increase by $250 million.

Q2.

(a)

Reserve requirement = 15% or 0.15

Calculate Money multiplier -

Money multiplier = 1/Reserve requirement = 1/0.15 = 6.67

The money multiplier is 6.67

(b)

Increase in amount of reserves by Fed = $200 million

Money multiplier = 6.67

Calculate increase in money supply -

Increase in money supply = Increase in amount of reserves by Fed * Money multiplier

                                      = $200 million * 6.67

                                      = $1,334 million

The money supply will increase by $1,334 million.

(c)

As one knows that higher the reserve requirement, lower will be the value of money multiplier and smaller will be the impact on money supply.

On the other hand, lower the reserve requirement, larger will be the value of money multiplier and larger will be the impact on money supply.

So, when Federal Reserve will increase the reserve requirement, the value of money multiplier will decrease.

As value of money multiplier will decrease, increase in reserves will have smaller effect on money supply.

Thus,

When the Federal Reserve increases the reserve requirement, the money multiplier will decrease and an increase in reserves will have a smaller effect on the money supply.

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