Question

Suppose that the required reserve ratio is 9%, currency in circulation is $620 billion, the amount of checkable deposits is $950 billion, and excess reserves are $15 billion.

a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money multiplier.

b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $1,300 billion due to a sharp contraction in the economy. Assuming the ratios you calculated in part (a) remain the same, predict the effect on the money supply.

c. Suppose the central bank conducts the same open market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?

d. Following the financial crisis in 2008, the Federal Reserve began injecting the banking system with massive amounts of liquidity, and at the same time, very little lending occurred. As a result, the M1 money multiplier was below 1 for most of the time from October 2008 through 2011. How does this scenario relate to your answer to part (c)?

Answer 1

money supply = currency with the public + demand deposits with the public
= 620 + 950
= 1570
currency-deposit ratio = 620 /950 = 65.36%
excess reserve ratio = excess reserves/deposits
= 15/950
= 1.58%
reserve ratio = required reserves ratio+ excess reserves ratio = 9%+1.58% = 10.58%
money multiplier = 1/reserve ratio = 9.45
increase in money supply = 1300*9.45= 12285

excess reserves = 15+1300 = 1315
excess reserve ratio = 1315/950 = 138.42%
the money supply = 1570
required reserves ratio+ excess reserves ratio = 147.52%
money multiplier = 1/147.52% = 0.6779

Answer to part depicts the same situation as the money multiplier is <1