Question

1. a) Draw the T-accounts for Fred’s Bank if the FED buys a $20,000 treasury security from Fred and Fred puts all the money he gets for it in the bank. Assume the reserve requirement set by the FED is 8%. (1 point)

b) Economist A claims that this will result in a change in the money supply of $250,000. Explain how this is possible. (1 point)

c) Economist B claims that the data shows the money supply only went up by $200,000. Explain how this is possible. (2 points)

Answer 1

The increase in money supplied can be measured by= Initial value x (1/reserve requirement)

so $20000 x (1/.08) = $250000

The explaination for the above is as follows-

Fred receives $20000 from the Feds for treasury bonds which he will go and deposit into his bank. The bank has 20000 now,it will keep some part of it as the reserve requirement of 8% which = 1600 and will have excess reserve = 18400 on which bank will make loan to the people.

Suppose the bank loans the amount to X who will deposit the money in his bank on which his bank will keep some part of it as reserve = 1472 and loan the excess reserve= 16928 to someone else.

This is known as the money multiplier effect where required amount of money is kept as reserve and the excess reserve is loaned out which keeps on multiplying that would result in the money supply of $250000 in this case.

Note- This is only a theoretical maximum that a given fixed amount can reach which is based on a reserve requirement.

The actual money supply in the market is always different and never reaches this theoretical maximum as some money reserves are held as cash in hand outside of banks which the customers never deposited into the banks so the the actual reserves and excess reserves will differ as in previous case.

So,both the Economists are right in their claims.