Question

Suppose the nation’s Central Bank (CB) decides to engineer an increase in the nation’s money supply, and begins the process with an open market operation (OMO), in which the CB purchases 2000₺ worth of Treasury securities from Household j (HH j). HH j deposits the entire 2,000₺ in cash into a demand deposit account at Bank A. Thus, the initial increase in total bank reserves is 2,000 ₺ cash in the vault.The CB has set the reserve requirement ratio (rd) at 50%. Bank A then lends out the entire increase in excess reserves. The increase in the money supply at this point is:

Answer 1

The above scenario can be explained with the help of Money Multiplier and fractional reserve banking system. Under such a system, when some initial deposits are made into a bank it increases the reserves of the bank. The banks are required to keep a part of that money in the form of Required Reserves. However, they do not keep all of the reserves with them but loan out the rest of the excess reserves. By loaning out money, banks are able to create new money in the economy and the process is known as Money Creation Process via Money Multiplier.

Money Multiplier = 1 / Required Reserve Ratio (rd)

Change In Money Supply = Money Multiplier x Change in Deposits

Let MS = Money Supply

MM = Money Multiplier

D = Deposits

d = delta (Change)

rd = required reserve ratio

dMS = MM x dD       

In the, given questions Required Reserve Ratio (rd) = 50% = 0.50 and Initial deposits in Bank A = 2000₺

· The required reserve for bank A = 0.50 * 2000 = 1000₺

· The amount of loan that Bank A could make at this point = 2000 – 1000 = 1000₺

· So the increase in money supply at this point = 1000₺

**Note: If the above process keeps on continuing until all excess reserves are loaned and all deposits are exhausted, the money multiplier would be = 1/0.50 = 2 and the total money supply at the end would be 2x2000 = 4000₺ . The total change on money supply would be 4000 – 2000 = 2000₺