Question

1. Assume that required reserve ratio is %20 and you deposit 1000$ to Bank A as demand deposit. What is the value of the money multiplier? By how much does the money supply increase? Explain.

2. Explain the effects of an expansionary fiscal policy on output when investments are insensitive to interest rate?

Answer 1

Q1) The value of the money multiplier is given by = 1 / required reserve ratio

= 1/0.2 = 5

This is because of the higher the reserve ratio, the lower os the capacity of the bank to lend out of new deposits. Thus, there is an inverse relationship between the reserve ratio and the money multiplier.

Increase in money supply = money multiplier*increase in deposits

= 5*1000

= $5000

This is the maximum amount by which the money supply can rise if the banks do not keep any excess reserves.