Question

Suppose the money supply is currently $500billion and the Fed wishes to increase it by $100 billion. a) Given a required reserve ratio of 10%, how much the Fed should increase money supply? (1 pt.) b) If the Fed decided to change the money supply by changing the required reserve ratio, what should the required reserve ratio be? (2 pts.)

Answer 1

a) Money multiplier = 1 / RR = 1 / 0.10 = 10

To increase $100 billion, the Fed should increase money supply by $25 billion [i.e. $100 billion / 4 = $25 billion].

b) At a required reserve ratio of 10%, the money multiplier is 1 / 0.10 = 10.

Therefore, to increase the money supply by $100 billion, it must increase bank reserves by $100 / 10 = $10 billion.

The money supply is currently $500 billion, it means that reserves must be $500 / 10 = $50 billion. It must set the money multiplier equal to $600 / $50 = 12.

It means that the required reserve ratio must be such that 1 / RR = 12,

or RR = 1 / 12 = 0.0833   or 8.33%

Thus , the required reserve ratio should be 8.33%