Question

For all questions assume the following starting point: The money supply (M) is composed of currency (C) held by the non-bank private sector (NBPS) and demand deposits (DD) held at banks. Banks are required to hold cash reserves (CR) equal to 10% of their demand deposit liabilities. The remainder of the banks DD liabilities are backed by loans (L). Initially banks have 2000 in cash reserves and the NBPS holds 500 in currency. Currently, banks no not hold excess reserves.

a) What are the initial values for DD, L and M?

b) What happens to the values in part a, if the NBPS decides to hold an additional 200 in currency?

c) What would happen to the values in part a if banks decided to hold 2.5% excess reserves?

d) What happens to the values in part a if concerns about the economy's future caused both b and c to happen?

e) If nominal GDP is 5.5 times the money supply, what happens to nominal GDP in parts a-d

Given the result in part-d, what open market operation would you use to keep the money supply at the level in part a of Module 5?

Answer 1

a. A simple format of bank balance sheet -

Total Assets	$	Total Liabilities	$
Cash reserves 10% of DD	2000	Demand Deposits (DD)	20000
Loans (L)	18000
Total	20000	Total	20000

Given, Currency with NBPS (C) = 500

Money Supply (M) = DD + L + C = 38500

b. If NBPS wants to hold additional 200 in currency(i.e. C=700), DD= 19800, L= 17820 and

M will be = 19800+17820+700= 38320

c. If banks want to keep 2.5% of excess reserves, then Balance sheet will be -

Total Assets	$	Total Liabilities	$
Cash reserves 10%	2000	Demand Deposits (DD)	20000
Excess Reserves 2.5%	500
Loans (L)	17500
Total	20000	Total	20000

So Money supply = 17500 + 20000 +500 = 38000

d. If both b. and c. happens due to concerns about economy, balance sheet will be,

Total Assets	$	Total Liabilities	$
Cash reserves 10%	1980	Demand Deposits (DD)	19800
Excess Reserves 2.5%	495
Loans (L)	17325
Total	20000	Total	20000

Currency with NBPS= 500+200=700

Therefore M =  17325+ 19800 +700 = 37825