Question

The central bank of Macroland conducts an open market purchase of government bonds, which is worth 1 million dollars. (i) If the required reserve ratio is 10% and commercial banks keep only the required amount to maximize the loans; and (ii) if people keep a half of their money holdings in currency, how much change in M1 money will be generated? Is the money multiplier greater or smaller (1/RR). Explain your idea with the balance sheet of commercial banks.

Answer 1

1. There will be change in M1 money supply by the open market operation but there won't be any change by lending of bank or customers keeping half of the amount as cash because cash held by public and in deposits are all part of the M1 money supply. Money Multiplier is a concept which is based on the compounding power of the money. The deposits in the bank become the credit for businesses which in turn deposit this money further and it is further used for lending. So, a larger amount of deposits and lesser reserves always lead to higher multiplication of money. MM will remain the same because MM is calculated by 1/RR which is same in both cases. Only the amount generated will be lower due to lower principal.

MM = 1/RR = 1/ 10% = 10

Example:

1. 1 Million acquired by public. They will keep 1/2 of it and deposit the other half in bank.

So,

Bank balance sheet:

Liabilities:

Deposits: 500,000

Assets:

Loans: 450,000

Reserves: 50,000

This 450,000 will become deposits for some other bank:

Liabilities:

Deposits: 450,000

Assets:

Loans: 405000

Reserves: 45000

This will continue until the 10x multiplication done of the original amount.

for the entire submission, the final figure will be higher but Money multiplier remains same but the amount generated will be higher due to higher principal.