Question

1. The banking system currently has $200 billion of reserves, none of which are excess. People hold only deposits and no currency, and the reserve requirement is 4 percent. If the Fed raises the reserve requirement to 10 percent and at the same time buys $50 billion worth of bonds, then by how much does the money supply change?

a. It rises by $600 billion.

b. It rises by $125 billion.

c. It falls by $2,500 billion.

d. None of the above is correct.

Answer 1

Answer 1

The correct answer is (c) It falls by $2,500 billion.

Money Supply = ((1 + Cr)/(Cr + rr + er))* Monetary Base

where er = excess reserve ratio and Cr = Currency to deposit ratio and Monetary Base = Currency + Reserves

As excess reserve = 0 and People hold no currency => Cr = 0 , er = 0 and Monetary Base = Reserves

Money Supply = (1/rr)*Reserves

Initially rr = required reserve ratio = 4% = 0.04 and Reserves = 200 billion

=> Money supply = (1/0.04)*200 billion = 5000 billion

Now Fed changes rr to 10% => rr = 10% = 0.10

Also It buys $50 billion worth of bonds and which finally results in increase in reserves by $50 billion.

So, New Reserves = 250 billion.

=> New money supply = (1/0.10)*250 billion = 2500 billion.

Hence Change in Money supply = 2500 billion - 5000 billion = -2500 billion( this negative sign implies that Money supply is decreasing)

So, Money supply will decrease by $2500 billion

Hence, the correct answer is (c) It falls by $2,500 billion.