Question

Suppose that currency in circulation is $800 billion, the amount of checkable deposits is $1200 billion, the required reserve ratio is 10% and excess reserves are $12 billion.

a. Calculate the money supply, the currency-to-deposit ratio, the excess reserve ratio, and the money multiplier.

b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $2000 billion due to a sharp contraction in the economy. Assuming the ratios you calculated in part (a) remain the same, predict the effect on the money supply.

c. Suppose the central bank conducts the same open market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis and bank run. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?

d. Please type answer

Answer 1

(a)

Money supply ($ Billion) = Currency + Checkable Deposits = 800 + 1200 = 2000

Currency-deposit ratio (cr) = Currency + Checkable Deposits = 800 / 1200 = 2/3 (= 0.67)

Excess reserve ratio (er) = Excess reserves / Checkable deposits = 12 / 1200 = 0.01

Required reserves ratio (rr) = 10% = 0.1 (given)

Money multiplier (MM) = (1 + cr) / (cr + er + rr) = (1 + 0.67) / (0.67 + 0.01 + 0.1) = 1.67 / 0.78 = 2.14

(b)

Open market purchase will increase money supply in economy.

Increase in money supply ($ Billion) = Open market purchase x MM = 2000 x 2.14 = 4280

(c)

New value of excess reserves ($ billion) = 12 + 2000 = 2012

New value of checkable deposits ($ Billion) = 1200 + 2000 = 3200

New value of er = 2012 / 3200 = 0.63

New value of money supply ($ Billion) = Currency + New value of Checkable Deposits = 800 + 3200 = 4000

New value of money multiplier = (1 + 0.67) / (0.67 + 0.63 + 0.1) = 1.67 / 1.4 = 1.19