Question

2) Banks hold 20% of deposits in reserve.

a. In order to stimulate the economy and increase investment, the fed _Buys _ (buys/sells) $1000 treasuries. [5pts]

b. The money base ____________ (increases/decreases) by _____________. The Money supply ___________ (increases/decreases) by _____________. [5pts]

c. Demonstrate what happens in the market for loanable funds. [15pts]

Answer 1

Reserve holding = 20%

Money multiplier = 1 / Reserve Holding = 1 / 20% = 5

a) In order to increase investment, Fed buy bonds worth 1,000 in exchange on giving cash to public which result in increase in investment.

b) The money base increase by 1,000. The money supply increase by 1,000 * Money multiplier = 1,000 * 5 = 5,000

c) As Fed supply funds to the public which reduce the supply of loanable funds due to fall in reserves of bank. Decrease in supply of loanable funds will result in increase in rate of interest in economy.