Question

1. Suppose that the reserve requirement is 10%.

a) Using the formula, what money multiplier would this imply?

b) Why might the actual money multiplier be smaller, particularly in a recession?

2. How does an expansion of the money supply affect interest rates? How does a contraction in the money supply affect interest rate?

3. The components of aggregate demand are C, I, G and X-M.

a. How is consumption affected by an increase in interest rates? Why?

b. How is investment spending affected by an increase in interest rates? Why? (Recall that investment here is private purchases of or improvements in productive goods and plant. It is not an individual's "investment" in stocks or bonds.)

Answer 1

Question 1

Reserve requirement = 10% or 0.10

Calculate the money multiplier -

Money multiplier = 1/rr = 1/0.10 = 10

The money multiplier is 10.

(b)

The simple money multiplier is calculated on the assumption that banks do not keep any excess reserves. In other words, they lend all the excess reserves.

However, during recession, banks do not lend all the excess reserves.

They kept significant portion of excess reserves with themselves.

This holding of excess reserves results in lower value of actual money multiplier.

Due to this reason, actual money multiplier might be smaller, particularly in a recession.