Question

1. i)    Tilaknesia has a reserve ratio of 20% in its banking system. Calculate the simple money multiplier.                                                                               (0.5 marks)

2. On a given day customers deposit $3,300 into their banks. Based on the simple money multiplier calculated in part i), calculate the total amount that the money supply in the banking system will eventually increase to.                       (0.5 marks)

3. Calculate the total amount that the money supply in the banking system will eventually increase to if the reserve ratio decreases to 16%.  Assume the amount of fund initially deposited by customers remain at $3,300.     (1 mark)                                                         
4. Explain in detail how the money multiplier process works.                       (1.5 marks)

2. In order to maintain a stable and low inflation, European Central Bank (ECB) would like to increase the interest rates in the economy.  What open market operation (OMO) action should the ECB take? Explain in detail the OMO process and its implications for the cash rate, interest rates, inflation and GDP. Draw by handthe effect of the OMO process using the Money Demand-Money Supply (MD-MS) diagram.                                                                                                          

Answer 1

Ans i) Mulitplier formula :

= 1/RR

Where,

RR = reserve ratio

Multiplier = 1/0.2 = 5

Ans ii) As deposit = $3300

Money supply calculation with multiplier :

=> multiplier × deposit

=> 5 × 3300

Money supply = $16500

Ans iii) As the new reserve ratio = 16%

New multiplier = 1/0.16 = 6.25

New money supply = 6.25 × 3300 = $20,625

Ans iv) The money multiplier is the magnitude of the change in the money supply with the proportionate change in the base money.

Suppose the reserve ratio is equal to 10% initially and the customer deposits $100 in the bank.

The bank keeps $10 and lends out the rest $90.

The customer who gets the $90 loan further deposits it in the bank and the bank keeps the $9 reserves with it and loans out rest $81 dollars to another customer.

This process continues until the final deposit amount becomes 0 or when bank don't have any reserves to make loans.