Question

Suppose the banks in an economy have a reserve-deposit ratio of 10 percent and the currencydeposit
ratio is 20 percent.
a. If the Central Bank decreases the monetary base by $400 through open market
operations, what will be the decrease in the money supply?
b. If the Central Bank increases the discount rate and firms react by increasing the reservedeposit
ratio to 20 percent, what is the change in the multiplier? Will this change increase
or decrease the money supply?
c. There is a rumor circulating that bank accounts are being hacked so many persons
withdraw their deposits from the bank. What impact does this have on the money
multiplier, high-powered money, and the money supply?

Answer 1

We have a reserve-deposit ratio = 10 percent and the currency deposit ratio = 20 percent. This implies that the money multiplier is 1 + C-D / C-D + R-D = (1 + 0.2)/(0.2 + 0.1) = 4. Now money market has the following multiplier equation

Change in money supply = money multiplier x change in monetary base

a. If the monetary base is reduced by $400 then the decrease in the money supply would be 4 x 400 = $1600

b. If there is an increases in the discount rate and the new reserve deposit ratio is 20 percent, multiplier is changed to (1 + 0.2)/(0.2 + 0.2) = 3. This will decrease the money supply and now the money supply will increase only to 3 x 400 = $1200.  

c. People are expected to withdraw their deposits from the bank. This reduces deposits and increases currency so C-D ratio increases. Now with higher C-D ratio, multiplier is reduced. The high-powered money or monetary base will increase because currency is increased and reserves are reduced. However, money supply will decline.