Question

You are given the following data regarding a Latin American country currency=50 billion                                                                                                                       
demand deposits=100 billion                                                                                                       
bank reserves=20 billion                                                                                                                   
a. Define and calculate the following                                                                                           
monetary base                                                                                                                                     
money supply                                                                                                                                  
money multiplier                                                                                                                               
b. Suppose during the month of May country’s central bank gains international resererves by an amount equal 10 billion. Assuming Central Bank credit remains unchanged,
what will be impact the gain in international reserves on:monetary base, money supply                                                                        
c. The goverment wants to keep the money supply unchanged in spite of gain of reserves . what offeseting operation could it engage in?

Answer 1

Required Reserve ratio (RR) = Bank Reserves (R) / Demand Deposits (D) = 20 / 100 = 0.2

Currency deposit ratio (cr) = Currency (C) / Demand Deposit (D) = 50 / 100 = 0.5

(a)

(i) Monetary base (MB) is the total value of currency and bank reserves. It is computed as:

MB ($ billion) = 50 + 20 = 70

(ii) Money supply (MS) is the total quantity of money in the economy at a specific point of time, computed as:

MS ($ billion) = C + D = 50 + 100 = 150

(iii) Money multiplier (MM) is the ratio of Change in money supply to Change in monetary base, computed as:

MM = (1 + CR) / (CR + RR) = (1 + 0.5) / (0.5 + 0.2) = 1.5 / 0.7 = 2.14

(b)

(i) $10 billion increase in reserves will increase monetary base by $10 billion.

(ii) Total Increase in MS ($ billion) = Increase in Monetary base x Money Multiplier = 10 x 2.14 = 21.4

(c)

Central Bank can lower domestic Money supply bycontractionary monetary policy. This can be achieved by open market sale of government securities, or by raising bank (discount) rate or by raising required reserves ratio.

Alternately, central bank can sell international currency and buy domestic currency to stabilize the domestic money supply. This is called a Sterilization operation.