Question

Assume that Elliott deposits $1,000 in coins he collected into his checking account. The required reserve ratio for the banking system is 10% and Elliott’s bank was fully loaned up prior to his deposit.

Explain the immediate effect of his deposit on the M1 measure of the money supply.

Calculate the following:

the maximum amount the bank will loan out

the maximum increase in the money supply as a result of this transaction

Now assume that the Federal Reserve purchases $10 million in government bonds.

Calculate the maximum increase in the total money supply.

Given the increase in the money supply when the Federal Reserve purchases bonds, are people with fixed incomes better off, worse off, or unaffected? Explain.

Answer 1

1)Money supply will increase more than $1,000 (Pl. read how bank create money)

If the required reserve ratio is 10% - therefore you have to deduct 10% and rest will be available to loan out. But you have to know that when bank offers loan to a person - bank actually credited his account -moreover the person also does not take out all money at one go. This gives opportunity to the bank to give loan to the second , third person- now money supply will depends on the transaction and withdrawal of the money. When FR purchase bond it means equivalent money is injected in the economy. But money supply will increase much more than that - role played by the banks, transaction and velocity of money.
The purpose of purchasing bond is to give boost to the economy- it will increase demand , investment , employment . But if the economy reaches near or full employment level it will likely to generate inflation. The fixed income earners will suffer most.

(OR)

1)money supply will increase=1/0.1 x 1000=$10,000.

2.) a $10 million purchase will increase money supply= 10x10=$100 million.
3.)worse off due to inflation.