Question

Suppose that the reserve requirement for checking deposits is 10 percent and that banks do not hold any excess reserves.

1. If the Fed sells $4 million of government bonds, what is the effect on the economy’s reserves and money supply?
2. Now suppose the Fed lowers the reserve requirement to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

Answer 1

Solution:-

(a). With a required reserve ratio 10% and no additional reserves, the money multiplier is

Money Multiplier = 1 / 0.10

                 = 10

Money supply increases by 10 x 4 Million = 40 Million

(b). If banks choose to hold 5% of deposit as excess reserve and reserve requirement ratio is 5% , the total reserve will be 10% which is same as earlier, the might hold excess reserve in order to manage daily operations.

Hence there will be no change in money multiplier and money supply by taking these actions.