Question

1. If reserves decrease by $4 million and the required reserve ratio is 6%, what is the change in the money supply?

2. According to Simple Quantity Theory of Money, what is the change in price level if money supply increases by 20% from $500 and both velocity and quantity are constant, at 2 and 100 respectively?

Answer 1

1.

The change in reserve changes the deposit by the same amount initially. the money supply changes by the multiplier time of changes in initial deposit. A multiplier measures the change in a variable due to one unit initial change in the independent variable. In this case, the multiplier measures the change in the money supply due to one unit change in a deposit. The money multiplier is reciprocal of the required reserve ratio mathematically. Therefore,

Assuming and rr=0.06

Therefore, as a result of a decrease in reserve by $4 million, the money supply decreases by $66.67 million.

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2.

The simple quantity theory of money is given as

By the growth equation, the QTM can be written as

The vector sign on top of the variables () denotes the rate of change of the variable. Now V and Q remain constant. Therefore,

Then if money supply changes by 20% keeping V and Q constant, then the price level will also increase by 20%. This is also known as the neutrality of money. The change in money supply changes price level by the same proportion keeping real values of the variables unchanged.