Question

Let’s say the Federal Reserve buys $20 Billion in bonds from private banks:

*Total reserve requirement = 0.10 x $1Trillion = $100 Billion

• What is the total amount (in $) of reserves that banks can lend?
• Using the simple deposit multiplier, how much additional money (M1) is created by this process?
• What will happen to the Federal Funds Rate, the prime rate, and other nominal interest rates in the economy? (Go up, down, stay the same?) Why?
• If the price level stays the same, what will happen to real interest rates? (Go up, down, stay the same?)
• What effect will this policy have on investment? Why?
• What effect will this policy have on consumption? Why?
• Is this monetary policy or fiscal policy? Contractionary or expansionary? Explain.
• Thinking about the relationship between aggregate demand, short-run aggregate supply, and long-run aggregate supply:
  • When would this policy be appropriate? Explain.
  • When would this policy be inappropriate? Explain.

• Please study the table below:

  • Category	Value
    Total Reserves (private banks)	$100 Billion
    Currency (firms, households)	$50 Billion
    Value of Euros in the U.S. (private banks, firms, households)	$1 Billion
    Gov’t bonds (private banks, firms, households)	$30 Billion
    Demand deposits (private banks)	$1 Trillion
    Certificates of Deposit, CDs (private banks)	$10 Billion
    Reserve requirement on demand deposits

Answer 1

a. Since 10 per cent is the reserve requirement, thus, reserves that can be lend = 90 per cent of 20 billion or the amount of bonds purchased = $18 billion.

b. The simple deposit multiplier states that increase in money supply = 1/ required reserve ratio = 1 / .10 * 18 billion = $180 billion.

c. Purchase of bonds leads to increase in the level of money supplied in the economy,increase in the money supply in the economy reduces  Federal Funds Rate, the prime rate, and other nominal interest rates in the economy. Thus all the rates will go down in the economy.

d. If price level stays the same, then real rate of interest in the economy will fall because real interest rate = Nominal interest rate - Inflation rate.