Question

8. The reserve requirement, open market operations, and the money supply

Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $500. Determine the money multiplier and the money supply for each reserve requirement listed in the following table.

Reserve Requirement	Simple Money Multiplier	Money Supply
(Percent)		(Dollars)
25
10

A lower reserve requirement is associated with a (larger/smaller)   money supply.

Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to (buy/sell) __$_______ worth of U.S. government bonds.

Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to (rise/fall) to (1/2.5/4/10) . Under these conditions, the Fed would need to (buy/sell) _$________ worth of U.S. government bonds in order to increase the money supply by $200.

Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply.

The Fed cannot prevent banks from lending out required reserves.

The Fed cannot control the amount of money that households choose to hold as currency.

The Fed cannot control whether and to what extent banks hold excess reserves.

Answer 1

1. Multiplier = 1/Reserve requirement = 1/0.25 = 4

Multiplier = 1/0.10 = 10

Money supply when r = 25% is Multiplier x Total reserves = 4 x 500 = $ 2000

Money supply with r = 10% is 10 x 500 = $ 5000

Lower reserve requirement means Larger money supply.

When Fed wants to increase money supply:

200 = Multiplier x Buying bonds

200 = 10 x Buying bonds

Buying bonds = 20

Fed should buy $ 20 worth of government bonds.

Money multiplier fall from 1/0.10 = 10 to 1/0.25 = 4. So, Fall to 4.

Now, 200 = 4 x Buying bonds

Buying bonds = $ 50

So, Fed should buy $ 50 worth of US government bonds.

The Fed cannot control the amount of money that households choose to hold as currency.

The Fed cannot control whether and to what extent banks hold excess reserves.