Question

8. The reserve requirement, open market operations, and the money supply Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $300. Determine the money multiplier and the money supply for each reserve requirement listed in the following table. Reserve Requirement Simple Money Multiplier Money Supply (Percent) (Dollars) 5 10 A higher reserve requirement is associated with a money supply. Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to $ worth of U.S. government bonds. Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to to . Under these conditions, the Fed would need to $ worth of U.S. government bonds in order to increase the money supply by $200. Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply. The Fed cannot prevent banks from lending out required reserves. The Fed cannot control whether and to what extent banks hold excess reserves. The Fed cannot control the amount of money that households choose to hold as currency.

Answer 1

(1) Checkable deposits = Total reserves = $300

Money multplier (MM) = 1 / Reserve requirement (RR)

Money supply = Deposit x MM

(i) When RR = 5% = 0.05

MM = 1 / 0.05 = 20

Money supply ($) = 300 x 20 = 6,000

(ii) When RR = 10% = 0.1

MM = 1 / 0.1 = 10

Money supply ($) = 300 x 10 = 3,000

(2) Higher reserve requirement is associated with Lower money supply.

(3) When Fed wants to increase money supply by $200 and RR = 10% (i.e. MM = 10),

Fed will use open market operations to Buy $20 worth (= $200 / MM = $200 / 10 = $20) government bonds.

(4) When RR increases from 10% to 25%,

Increase in RR causes money multiplier to Decrease to 4 (= 1 / 0.25). Under these conditions, Fed will have to Buy $50 worth (= $200 / MM = $200 / 4 = $50) government bonds.

(5) Reasons why Fed cannot precisely control money supply are:

- Fed cannot control whether and to what extent Banks hold excess reserves (The higher (lower) the amount of excess reserves banks hold back, the lower (higher) the increase in money supply).

- Fed cannot control amount of money households choose to hold as currency (The higher (lower) the currency drainage ratio, the lower (higher) the MM and the lower (higher) the money supply)