Question

16. Explain how each of the following would influence the money multiplier and the supply of money:

A. The central bank buys government bonds in the open market.

B. A run on the banks to withdraw deposits.

C. The Fed reduces banks’ ability to borrow from the Fed.

Answer 1

Ques16-

Ans16-When the central bank buys government bonds in the open market,it increases the reseves of the commercial banks which as a result affects the credit creating power of the commercial banks i.e it increases and therefore it leads to rise in money supply in the economy.Since the banks are able to create more credit,it increases the value of money multiplier as it is able to create more money in form of deposits with every unit of it kept as reserves.

Ansb-When there’s a run on the banks to withdraw deposit,many people withdraw their money simultaneously out of the banks over concerns of  bank’s solvency this provokes more people to withdraw their deposits. As a result the banks will loan the excess reserves after keeping some of it with itself and this increases the money supply in the economy. And in order to make money available in hand at the time of withdrawal of deposit by people the bank reduces it’s lending which as a result reduces the value of money multiplier.

Ansc-When Fed reduces the bank’s ability to borrow from Fed,i.e when Fed increases it’s interest rates( mostly known as repo rate or bank rate),it increases the borrowing rates from central bank as a result of this commercial banks increase their lending rates which seems less attractive to borrowers.The credit creating ability is reduced which leads to fall in money supply in the economy.The value of money multiplier will fall because of increase in lending rates.