Question

Suppose the Federal Reserve decided to buy $50 billion worth of government securities in the open market a. By how much will M1 change initially if the entire $50 billion is deposited into transactions accounts Note: If M1 decreases be sure to include a negative sign (-) in front of your answer. M1 will initially change by: billion b. How will the lending capacity of the banking system be affected if the reserve requirement is 5 percent? Note: Il lending capacity decreases be sure to include a negative sign (-) in front of your answer Total lending capacity will change by: c. How will banks induce investors to respond to this change in lending capacity? If the money supply increases, interest rates will and investors will want to borrow more funds. If the money supply decreases, interest rates will and investors will want to borrow fewer funds.

Answer 1

a)

Answer: $ 50 Billion.

M1 includes currency and demand deposits. The currency is immediately deposited, hence there will be a rise in the M1 equal amount or $ 50 Billion.

b)

Answer: $ 1000 Billion.

Money Multiplier = 1/rr

= 1/0.05

= 20

Rise in the lending capacity =20*50

= 1000

c)

If money supply increases, the interest rate will Decline and investors will find want to borrow more funds.

If money supply decreases, the interest rate will Rise and investors will want to borrow fewer funds.