Question

Suppose that the required reserve ratio is 8%, currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, and excess reserves are $15 billion.

a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money multiplier.

b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $ 1,100 billion due to a sharp contraction in the economy. Assuming the ratios you calculated in part (a) remain the same, predict the effect on the money supply.

c. Suppose the central bank conducts the same open market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?

d. Following the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this relate to your answer to the previous step?

Answer 1

Suppose that currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, the required reserve ratio is 8% and excess reserves are $15 billion.

A. Calculate the money supply,

the currency-to-deposit ratio,

the excess reserve ratio, and

the money multiplier

Money supply:

M = Currency in circulation + Currency Deposits = $600 + $900 M =$1500 billion

Currency-to-deposit ratio:    =Currency in circulation / Currency Deposits = $600 / $900 = 0.667

Required reserve = 10% of Currency Deposits   = 10% x $900 = $90billion

Excess Reserve Ratio: = Excess Reserves / Currency Deposits = $15/ $900 = 0.01667

Money multiplier = Money Supply/ Monetary base Monetary base = Currency in circulation + Excess Reserves

= 600 + 15 = $615 billion

Money multiplier = 1500/615 = 2.43

Thus, Money supply = $1500 billion

Currency Deposit Ratio = 0.667

Excess Ratio Reserves = 0.01667

Money Multiplier = 2.43

B) Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $ 1,100 billion due to a sharp contraction in the economy.

Money injected in the economy = $1100 billion This is included in checkable deposits as central bank would pay in the form of cheque to banks who issued bonds to central bank.

Therefore, Money supply = $1500 + $1100 = $2600 billion

C) Suppose the central bank conducts the same open market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis.

​​​​​​Calculate

Excess Reserves = $1100 + $15 = $1115 Billion

Excess Reserve Ratio = Excess Reserve/Checkable deposits

= $1115/$900 = 1.238

Money Supply = $600 + $900 = $1500 billion It remained Unchanged.

Money Multiplier = Money Supply / Monetary Base

Monetary Base = Excess Reserves + Cash in Circulation = $1115 + $600 = $1715

Money Multiplier = 1500/1715 = 0.874

Therefore, Excess Reserves = $1115 billion

Excess Reserve Ratio = 1.238

Currency in circulation = $1500 Billion

Money Multiplier = 0.87

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D) Following the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011.

​​​​​​The above (C) Part The money multplier is less than 1 when Federal Reserve did Open market operation and Purchase bonds and inject liquidity in the economy. So from above situation we could interpret such thing would happened exactly after financial crisis 2008 which implies Money multipler would be less than 1.

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