Question

2a. The reserve requirement is 20% and the FED buys 200 billion dollars of government securities. What is the maximum expansion possible in the money supply?

2b. (30 points) Explain how the change in the money supply in question 2a works its way through the economy to affect employment, inventories, GDP, and interest rates. Be sure to explain the causality chain, not just what happens to each variable.

Answer 1

a) Reserve Requirement = 20% = 0.2

Multiplier = 1 / Reserve Requirement  = 1 / 0.2 = 5

Fed buys 200 billion dollar of government security which will raise the money supply by 200 * Multiplier which is 200 * 5 = 1,000 billion dollar

b) As money supply rises in the economy, people would be less willing to borrow money while more people would be willing to lend money. As demand of loanable funds fall, interest rate will fall. Multiplier says that one person spending is another person income. When people spend 200 billion, it raises circulation of income by 5 times of it such as when a consumers buys something from a grocery store, owner of grocery store will give salary to their employees after keeping their profit and so on. It will raise the employment level in the economy because of rise in willingness to hire more labor. Due to rise in money supply, there would be rise in GDP level and fall in inventories due to high demand.