Question

Assume that the value of central bank money in a country is 5000$. Assume all transactions are electronic (no cash) and the reserves coefficient for banks is 10%.

a. Compute the money supply in the country. [2p]

b. Who holds the 5000$ printed by the central bank? Explain your answer. [2p]

c. Suppose now that households want to keep 10% of their money as cash. Compute the money supply in the country, and motivate the variation with respect to point A. [2p]

Answer 1

(a)

Money supply ($) = Bank money / Reserve coefficient = 5,000 / 0.1 = 50,000

(b)

The amount of money printed by central bank is held by the public, in the form of coins, note and currency.

(c)

Money multiplier (MM) = (1 + Currency ratio) / (Currency ratio + Reserve coefficient) = (1 + 0.1) / (0.1 + 0.1) = 1.1 / 0.2 = 5.5

Money supply ($) = Bank money x MM = 5,000 x 5.5 = 27,500

Money supply falls when people keep money as cash. This decreases the amount of excess reserves in banking system which is available for credit lending. Since higher (lower) credit lending increases (decreases) money supply, a fall in credit lending will reduce money supply.