Question

Suppose that the required reserve ratio is 8% (i.e. rr = RR/D = 0.08), banks hold 5% of checking account deposits as excess reserves (i.e. e = ER/D = 0.05), and the currency-to-deposit ratio is 0.5 (i.e. c = C/D = 0.5).

     a.   Use this information to calculate the money multiplier.

     b.   How would your answers to part (a) change if banks become concerned about risks

            involved in making loans and now choose to hold 20% of checking account deposits as

           excess reserves (e = 0.20)? Compute the new value of the money multiplier.

c. Starting from part (a) what happens to money multiplier if people decide to hold more

           currency, resulting in an increase in currency-deposit from c = 0.5 to c = 0.8?

d. If the Fed conducts open market operations and buys $100 million in Treasury bonds from

banks, what will happen to money supply using the multipliers in part (a), (b), and part (c)?

Answer 1

Given that required reserve ratio rr = 8% and excess reserve ratio er = 5% and that currency-to-deposit ratio c = 50%

a) We know that money multiplier = (1 + c)/(rr + er + c) = (1 + 50%)/(8% + 5% + 50%) = 2.381

b) Now banks have become concerned about risks are holding an excess reserve ratio = 20%. New money multiplier = (1 + 50%)/(8% + 20% + 50%) = 1.9231. Hence multiplier value is reduced.

c. Now new currency-deposit is c = 0.8. Hence we have a new money multiplier = (1 + c)/(rr + er + c) = (1 + 80%)/(8% + 5% + 80%) = 1.9355

d. If the Fed conducts open market operations and buys $100 million in Treasury bonds from banks,

• part a) will increase money supply by 100*2.381 = 2381 million
• part b) will increase money supply by 100*1.9231 = 192.31 million
• part c) will increase money supply by 100*1.9355 = 193.55 million.