10. The COMPLEX fi nancial system has these relationships: The ratio of reserves

Question

10. The COMPLEX fi nancial system has these relationships: The

ratio of reserves to total deposits is 12 percent, and the ratio of

noncheckable deposits to checkable deposits is 40 percent. In addition,

currency held by the nonbank public amounts to 15 percent of

checkable deposits. The ratio of government deposits to checkable

deposits is 8 percent, and the monetary base is $300 million.

a. Determine the size of the M1 money multiplier and the size of

the money supply.

b. If the ratio of currency in circulation to checkable deposits

were to drop to 13 percent while the other ratios remained the

same, what would be the impact on the money supply?

c. If the ratio of government deposits to checkable deposits

increases to 10 percent while the other ratios remained the

same, what would be the impact on the money supply?

d. What would happen to the money supply if the reserve

requirement increased to 14 percent while noncheckable

deposits to checkable deposits fell to 35 percent? Assume the

other ratios remain as originally stated.

Explanation / Answer

Federal Reserve policy is the most important determinant of the money supply. The Federal Reserve affects the money supply by affecting its most important component, bank deposits.

Here is how it works. The Federal Reserve requires depository institutions (commercial banks and other financial institutions) to hold as reserves a fraction of specified deposit liabilities. Depository institutions hold these reserves as cash in their vaults or Automatic Teller Machines (ATMs) and as deposits at Federal Reserve banks. In turn, the Federal Reserve controls reserves by lending money to depository institutions and changing the Federal Reserve discount rate on these loans and by open-market operations. The Federal Reserve uses open-market operations to either increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The seller of the treasury security deposits the check in a bank, increasing the seller

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