Question

Suppose that the required reserve rate is five percent, banks want to hold excess reserves in an amount that equals five percent of deposits, and the public withdraws ten percent of every deposit in cash. An open market purchase of $1 million by the Fed will see banking system deposits increase by:

		$1 million.
		$5 million.
		$20 million.
		$5.5 million.

Answer 1

Given that

• the required reserve rate is five percent, RR-D = 0.05
• banks want to hold excess reserves equal to five percent of deposits, ER-D = 0.05
• public withdraws ten percent of every deposit in cash, C-D = 0.10

This makes the multiplier mm = (1 + C-D)/(C-D + RR-D + ER-D)

= (1 + 0.10)/(0.10 + 0.05 + 0.05) = 5.5

An open market purchase of $1 million by the Fed will see banking system deposits increase by multipler times the increase in monetary base

Increase in money supply = 1*5.5 = 5.5 million.