Question

5. Assume that the reserve requirement is 5 percent. All other things being equal:

Will the money supply expand more if the Fed buys $2,000 worth of bonds or if someone deposits in a bank $2,000 that he had been hiding in his cookie jar?

If one creates more, how much more does it create?

6. Assume that the banking system has total reserves of $100 billion. Assume also that required reserves are 10 percent of checking deposits and that banks hold no excess reserves and households hold no currency.

What is the money multiplier? _______What is the money supply? $__________

Answer 1

Question 5

Reserve requirement = 5% or 0.05

Money multiplier = 1/Reserve requirement = 1/0.05 = 20

The money multiplier is 20.

If Fed buys $2,000 worth of bonds then excess reserves with banks would increase by $2,000.

Calculate the total increase in the money supply -

Increase = Increase in excess reserves * Money multiplier

Increase = $2,000 * 20 = $40,000

The total increase in money supply when Fed buys $2,000 worth of bonds is $40,000.

If someone deposits $2,000 in the bank then new deposit of $2,000 will be created with the bank.

New deposit = $2,000

Required reserves = New deposit * Money multiplier = $2,000 * 0.05 = $100

Excess reserves = New deposits - required reserves = $2,000 - $100 = $1,900

Calculate the total increase in the money supply -

Increase = Excess reserves * Money multiplier

Increase = $1,900 * 20 = $38,000

The total increase in money supply when someone deposits $2,000 in the bank is $38,000.

Thus,

The money supply expand more if the Fed buys $2,000 worth of bonds.

It create $2,000 more in money supply.

Question 6

Required reserves = 10% or 0.10

Calculate the money multiplier -

Money multiplier = 1/required reserve ratio = 1/0.10 = 10

The money multiplier is 10.

Bank hold no excess reserves. This means total reserves held by bank are all required reserves.

Required reserves = Checkable deposits * Reserve ratio

Checkable deposits = required reserves/reserve ratio = $100 billion/0.10 = $1,000 billion

The checkable deposits are $1,000 billion.

Money supply includes currency and checkable deposits.

It is stated that households hold no currency.

Thus,

The money supply is $1,000 billion.