Question

1. Explain how each of the following events affects the monetary base, the money multiplier, and the money supply. a. The Fed increases the interest rate it pays banks for holding reserves. When the Fed increases the interest rate, it pays banks to hold reserves. b. The Fed flies a helicopter over 5th Avenue in New York and drops newly printed $100 bills. c. Rumors about a computer virus attack on ATM machines increase the amount of money people hold as currency rather than demand deposits.

Answer 1

a.) When the Fed increases the interest rate it pays banks for holding reserves, this gives banks an incentive to hold more reserves relative to deposits. The increase in the reserve deposit ratio will decrease the money multiplier. The decline in the money multiplier will lead to a decrease in the money supply. Since banks are holding more reserves (because they are making fewer loans), the monetary base will increase.

b.) If the Fed drops newly minted $100 bills from a helicopter, then this will increase the monetary base and the money supply. If any of the currency ends up in the bank, then there will be a further increase in the money supply. If people end up holding more currency relative to deposits, then the money multiplier would fall.

c.) If consumers lose confidence in ATMs and prefer to hold more cash, then the currency–deposit ratio will increase, and this will reduce the money multiplier. The money supply will fall because banks have fewer reserves to lend. The monetary base will increase because people are holding more currency, but will decrease because banks are holding fewer reserves. The net effect on the monetary base is zero.