Question

The FOMC has instructed the FRBNY Trading Desk to purchase $750 million in U.S. Treasury securities. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction deposits.

Assume U.S. banks withdraw all excess reserves and give out loans. Assume also that borrowers eventually return all of these funds to their banks in the form of transaction deposits.

What is the full effect of this purchase on bank deposits and the money supply? What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 90 percent of these funds to their banks in the form of transaction deposits?

Answer 1

a. $7.5 billion

Explanation:

Given that,

Treasury securities purchased = $750 million

Reserve requirement = 10% of the deposits

Therefore,

Transaction Deposits = 100% of 750 = 750

Other Deposits = 0

Increase in bank deposits and money supply:

= (1 / Reserved Requirement) * Transaction Deposits + Other Deposits

= (1 / 10%) * 750 + 0

= 10 * 750

= $7500 million

= $7.5 billion

Hence, there is an increase in the bank deposits and money by $7.5 billion.

b. $6.825 billion

Transaction Deposits = 90% of 750 = 675

Other Deposits = 750 - 675 = 75

Increase in bank deposits and money supply:

= (1 / Reserved Requirement) * Transaction Deposits + Other Deposits

= (1 / 10%) * 675 + 75

= 10 * 675 + 75

= 6750 + 75

= $6825 million

= $6.825 billion

Hence, there is an increase in the bank deposits and money by $6.825 billion.

Note;

If borrowers spent all funds they borrowed from banks, the deposit multiplier will be applied on 100% money whereas if only 90% is spend in transactions and other 10% is saved or deposited some other way then deposit multiplier will be applied on only 90% money and remaining 10% will not multiply.