Question

The FOMC has instructed the FRBNY Trading Desk to purchase $820 million in U.S. Treasury securities. The Federal Reserve has currently set the reserve requirement at 5 percent of transaction deposits. Assume U.S. banks withdraw all excess reserves and give out loans.
a. Assume also that borrowers eventually return all of these funds to their banks in the form of transaction deposits. What is the full effect of this purchase on bank deposits and the money supply?
b. What is the full effect of this purchase on bank deposits and the money supply if borrowers return only 95 percent of these funds to their banks in the form of transaction deposits?

a.	(increase or decrease)	in bank deposits and money supply		billion
b.	(increase or decrease)	in bank deposits and money supply		billion

Answer 1

a)$16.4 billion

Explanation:

Given that,

Treasury securities purchased = $820 million

Reserve requirement = 5% of the deposits

Therefore,

Transaction Deposits = 100% of 820 = 820

Other Deposits = 0

Increase in bank deposits and money supply:

= (1 / Reserved Requirement) * Transaction Deposits + Other Deposits

= (1 / 5%) * 820 + 0

= 20 * 820

= $16,400 million

= $16.4 billion

Hence, there is an increase in the bank deposits and money by $16.4 billion.

b.

Transaction Deposits = 95% of 820 = 779

Other Deposits = 820 - 779 = 41

Increase in bank deposits and money supply:

= (1 / Reserved Requirement) * Transaction Deposits + Other Deposits

= (1 / 5%) * 779 + 41

= 20 * 779 + 41

= 15580 + 41

= $15,621 million

= $15.62 billion

Hence, there is an increase in the bank deposits and money by $15.62 billion.

Note;

If borrowers spent all funds they borrowed from banks, the deposit multiplier will be applied on 100% money whereas if only 95% is spend in transactions and other 5% is saved or deposited some other way then deposit multiplier will be applied on only 95% money and remaining 5% will not multiply.