Question

If the rrr = 25% and you deposit $1,000 into your bank account, how much of it will banks have to set aside in their required reserve account (RR)? __________ How much will be left over to place into excess reserves (ER)? __________. Now, once ER changes, how much money can ultimately be created by our banking system? (5 points)

Suppose the Fed sets the required reserve ratio at 20% and there are no excess reserves at the time (ER = 0 as you start this problem). If the Federal Open Market Committee (FOMC) sells $20 million in bonds to Bank A, how much will this ultimately change the money supply and in what direction (increase MS or decrease MS)? (5 points)

Suppose the Fed sets the required reserve ratio at 10%. If the FOMC buys $50 billion in government bonds from Bank A, what will happen to Bank A’s excess reserves (ER)? How much can the MS ultimately change and in which direction? (5 points)

Answer 1

1) If the central bank were to set the reserve ratio at 25 % and there is an initial deposit of $1000 to the bank;

Amount to be set aside as reserves : 25/100 x 1000 = $250

Therefore $250 is to be set aside as reserves.

Amount available and created by bank: 1000 - 250 = $750

Therefore $750 is created by the bank and is added into the nation's money supply.

2) With no excess reserves in the bank and that the central bank has sold $20 million in bonds to bank A, this reduces the amount of money available with the bank. This thus reduces the money supply of the country by $20 million and the money supply curve shifts leftward. Therefore there is a decrease in money supply

The money supply curve is vertical and parallel to the Y axis as at any given point it is the level of money supply is constant in the economy. In the above case, the money supply curve shifts leftward from MS to MS1 indicating lower levels of available money (M1) in the economy.

3) The Central bank sets the reserve rate at 10% and it conducts open market operations where it buys $50 million bonds from Bank A. This increases the amount of money available in the bank as the fed pays the bank off $50 million in exchange of government bonds. Now, as the reserve rate is set at %10;

Amount to be set aside as reserves: 0.1 x 500,00,000 = 50,00,000 or $5 million dollars.

Amount generated and created by the bank = 50 million - 5 million = $45 million dollars.

As the amount generated by the bank has increased this results in the increase in money supply by $45 million dollars and thus induces the Money supply curve to shift rightward, indicating increase in money supply.

We see that the money supply curve shifts rightwards from MS to MS1 indicating higher level of available money M1 in the economy.