Question

3. If you deposit $400 in a bank account and the reserve ratio is 20 percent.

a. What is the minimum amount of money banks will be required to keep in reserves? How much loans can banks make at most? What is the money multiplier? How much money can be created from $400 of reserves?

b. If the fed raises the required reserve ratio to 30 percent. What is the minimum amount of money banks will be required to keep in reserves? How much loans can banks make at most? What is the money multiplier? How much money can be created from $400 of reserves?

c. How does the money supply change from part (a) to part (b)? Does it increase or decrease? What happens to the interest rate when the Ms changes from part (a) to part (b)? How does the changes in interest rates effects the AD? All else equal.

d. What policy is the fed trying to embark on?

e. What policy should the government take to stabilize the economy from fed’s policy effect?

Answer 1

3

a) Deposit = $400

Reserve ratio = 20%

Minimum amount of money banks will be required to keep in reserves? 20% of $400=$8.

How much loans can banks make at most?

$400-$8=$302

What is the money multiplier? How much money can be created from $400 of reserves?

Money Multiplier= 1/ Reserve Ratio

= 1/.2=5

Expansion of Money Supply= Money Multiplier x Excess Reserves

= 5 x $400=$2000.

b. If the fed raises the required reserve ratio to 30 percent. What is the minimum amount of money banks will be required to keep in reserves?

Minimum amount to be kept as reserves =30% of deposit, which is, $400=$12

How much loans can banks make at most? Bank can let out $400-$12=$382.

What is the money multiplier? How much money can be created from $400 of reserves?

Money Multiplier= 1/ Reserve Ratio

= 1/.3=3.33

Expansion of Money Supply= Money Multiplier x Excess Reserves

= 3.33 x $400=$ 1333.33

c) How does the money supply change from part (a) to part (b)? Does it increase or decrease?

Money supply decreases from $2000 to $1333.33=$666.67.

What happens to the interest rate when the Ms changes from part (a) to part (b)?

When money supply decreases, interest rates will rise.

How does the changes in interest rates effects the AD? All else equal.

AD will decrease.