Question

Question 1

The banking system plays a crucial role in carrying out monetary policy. Through the credit process within commercial banks, quantities of money are created for the economy.

a) In order to boost economic growth, the central bank of Country Y has injected $500 billion of new money into the banking system. If the required reserve ratio (RR) for bank deposits in Country Y is 20%, compute the maximum increase in money supply that the additional funds can create in the following scenarios:

i. Commercial banks in Country Y lend all their available funds to their loan customers under the current reserves requirement. At the same time, the public does not keep any cash on hand and deposit all their money to banks.

ii. Suppose the public keeps one third of their funds in form of cash and deposit the rest with their banks. In addition, commercial banks hold 5% excess reserves (ER) on top of the required reserve for the deposits they receive.

b )With reference to your answers in (a), explain in detail why a central bank in reality cannot control the exact amount of money in circulation with the practice of monetary policy.

Answer 1

a)

Overview: In the given case a total of $500 Billion have been injected into the economy by the central bank, through other banks. As a requirement of the Central Bank reserve ratio (RR) for bank deposits is 20%. The maximum increase in the money supply that the additional funds can create in the above-stated scenarios is solved as follows:

i. Commercial banks lend all their available funds (total funds injected - Statutory RR withheld), i.e. $ 400 Billion (500* 80%) to their loan customers. Therefore gross outflow of funds = $ 400 Billion

- At the same time, the public deposit all their money back to banks. Therefore gross inflow of funds = $ 400 Billion

- The maximum increase in money supply = Gross outflow of funds - Gross outflow of funds = 400 - 400 = Nil

ii. Commercial banks hold 5% excess reserves (ER) on top of the required reserve for the deposits they receive. Total money received by banks = $ 500 Billion. Total money withheld by them = 15%. Therefore gross outflow of funds = $ 425 Billion (500*85%)

- At the same time, the public deposit 2/3rd their money back to banks. Therefore gross inflow of funds = $ 283.33 Billion

- The maximum increase in money supply = Gross outflow of funds - Gross outflow of funds = 425 - 283.33 = $ 141.67 Billion.

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b) The central bank, in reality, cannot control the exact amount of money in circulation with the practice of monetary policy BECAUSE THE CIRCULATION OF MONEY IN AN ECONOMY DOES NOT DEPEND UPON THE MONEY INJECTED BY THE GOVERNMENT INTO THE ECONOMY OR THE RESERVE RATIO MADE BY THE GOVERNMENT, BUT ON THE AMOUNT OF MONEY WITHHELD BY THE PUBLIC AT LARGE, WITHIN THE ECONOMY.

In the above example, we have seen that Govt. wanted to increase the supply of money in hands of the public by $ 400 Billion, by injecting $ 500 Million and keeping The RR at 20%, but that clearly did not happen in both the cases above as the public ended up, depositing a fraction of the same money back in banks.