Question

The FOMC has instructed the FRBNY Trading Desk to purchase $740 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?

Answer 1

Answer: a)

$14.8 billion

Explanation:

Given that,

Treasury securities purchased = $740 million

Reserve requirement = 5% of the deposits

Therefore,

Increase in bank deposits and money supply:

=1/RR × Purchased amount

=1/0.05 × 740

= 20 × $740 million

= $14,800 million

= $14.8 billion

Hence, there is an increase in bank deposits and money by $14.8 billion.

Answer: b)

$7.4 billion

Explanation:

Given that,

Treasury securities purchased = $740 million

Reserve requirement = 5% of the deposits

Borrowers return only 95 percent of these funds

Therefore,

Change in bank deposits = [1/ (new reserve requirement + c)] × change in reserves created by reserve requirement change

where c the public’s cash-to-deposit ratio or preference for holding cash outside banks relative to bank deposits

c= 0.05 (or 5/100).

Thus, Change in deposits

= [1/(0.05 + 0.05)] × (740)

= $7400 million.

= $7.4 billion

Hence, there is an increase in bank deposits and money by $7.4 billion.