Question

Suppose the banks in an economy have a reserve-deposit ratio of 10 percent and the currency deposit ratio is 20 percent.

a. If the Central Bank increases the monetary base by $400 million through open market operations, what will be the increase in the money supply?

b. If the Central Bank decreases the discount rate and firms react by decreasing the reserve deposit ratio to 5 percent, what is the change in the multiplier? Will this change increase or decrease the money supply?

c. There is a rumour circulating that bank accounts are being hacked so many persons withdraw their deposits from the bank. What impact does this have on the money multiplier, high-powered money, and the money supply?

Answer 1

(a) initial investement (I) is 400 million $

legal reserve ratio= reserve deposit ratio + currency deposit ratio

LRR=10+20= 30%

increase in money supply= initial investment *

= 400 *

=1333.33 million $

money supply will increase by $1333.33 million.

(b)money multiplier =

k =

k = 20 times

money multiplier changes by 16.66667 times ( 20 times - 3.33333 times)

(c) as a lot of people withdraw their money from the banks, the banks face acute cash shortages for which the have to sell their assets to pay to people usually at loss.This is because banks only keep a fraction of their deposits with themselves while the rest is either lended or invested. this forces banks to either put a limit on withdrawals or raise the legal reserve ratios regarding remaining money due to which they cannot lend money which disrupts the money multiplier mechasnism and reduces the value of the multiplier. with increase in money supply due to mass withdrawals the purchasing power of money decrease as economy virtually enters the state of depression which in result reduces the value of the high powered money although more than ample is in the market but with lower value both in terms of purchasing power and with respect to foriegn currencies. IT IS ASSUMED THAT THERE IS A SINGLE BANK IN THE ECONOMY AND ALL TRANSACTIONS ARE ROUTED THROUGH THE BANK ITSELF.