Question

 

1. An economy has a monetary base of 1,300 $1 bills. Calculate the money supply in the following scenarios. (Note: use the identity M = C + D for (i), and the full money multiplier equation for the rest.)
   1. All money is held as currency.
   2. All money is held as demand deposits. Banks hold 100 percent of deposits as reserves.
   3. All money is held as demand deposits. Banks hold 5 percent of deposits as reserves.
   4. People hold equal amounts of currency and demand deposits. Banks hold 5 percent of deposits as reserves.
2. Explain how each of the following events, ceteris paribus, affects the monetary base, the money multiplier, and the money supply.
   1. The Fed buys bonds in an open-market operation.
   2. The Fed increases the interest it pays banks for holding reserves.
   3. Rumors about a computer virus attack on ATMs increase the amount of money people hold as currency rather than demand deposits.
3. By the end of December 2008, the money multiplier fell below 1.0 for the first time in history. Does this change the effect of increasing the currency-deposit ratio? Explain.

Answer 1

Part A

a) If all money is held as currency,

M = C + D

Monetary base = C+R

then the money supply = the monetary base. so the money supply = $1,300.

b) If all money is held as deposits, but banks hold 100 percent of deposits on reserve, it means to no loans. The money supply will be $1,300.

c) If all money is held as deposits and banks hold 5 percent of deposits on reserve, then the reserve–deposit ratio is 5/100=0.05 and the currency–deposit ratio is 0,

money multiplier (m)= (1+cr)/(cr+rr)= (0+1)/(0+0.05)=1/0.05=20

money supply= m*monetary base= 20*1300=$26000

d) If people hold an equal amount of currency and deposits, then the currency–deposit(C/D) ratio is 1. The reserve–deposit ratio is 0.05

money multiplier =(1+cr)/(cr+rr)= (1 + 1)/(1 + 0.05) = 1.90

money supply= m*monetary base= 1.90*1300=$2476.19

Part B

(a) When the Feb buys bonds in an open market operation, the dollars that it pays to the public for the bonds increase the monetary base, because monetary base is the sum of Currency and Reserve if currency increase then monetary base increase and this, in turn, increases the money supply.

The money multiplier is not affected by assuming no change in the reserve-deposit ratio or the currency-deposit ratio.

(b) When the Fed increases the interest rate it pays banks for holding reserves, it means bank gives an incentive to hold more reserves relative to deposits t

money multiplier =(1+cr)/(cr+rr)

increase in rr due to holding reserve and money multiplier will decrease that decline in the money multiplier leads to a decline in money supply(money supply= m*monetary base).

(C) If consumers lose confidence in ATMs then consumer want to hold more cash in hand, that leads to increasing the currency–deposit ratio, and this will reduce the money multiplier(1+cr)/(cr+rr)). The money supply will fall (.money supply= m*monetary base). The monetary base will increase because people are holding more currency, but will decrease because banks are holding fewer reserves. The net effect on the monetary base is zero.