Question

8. The reserve requirement, open market operations, and the moneysupply Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $300. Determine the money multiplier and the money supply for each reserve requirement listed in the following table. Reserve Requirement (Percent) Money Supply (Dollars) Simple Money Multiplier 10 A higher reserve requirement is associated with a money supply Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to $ worth of U.S. government bonds. Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to t o . Under these conditions, the Fed would need to $ worth of U.S. government bonds in order to increase the money supply by $200.

Answer 1

Total reserves of the banking system are equal to 300. There is no currency or excess reserves. Simple deposit multiplier = 1/RR = 1/reserve requirement ratio When RR = 5%, money multiplier = 1/5%= 20. Money supply = 300*20 = 6000 When RR = 10%, money multiplier = 1/10% = 10. Money supply = 300*10 = 3000 Higher reserve requirement is related to lower money supply If money supply has to be increased by 200 and reserve requirement is 10%, then multiplier is 10 and we need an increase in monetary base = 200/10 = 20 Hence open market operations to purchase/buy $20 worth of bonds are required. Increase in reserve ratio will reduce the multiplier from 10 to 1/25% = 4. Now if money supply has to be increased by 200 and reserve requirement is 25%, then multiplier is 4 and we need an increase in monetary base = 200/4 = 50. Hence open market operations to purchase/buy $50 worth of bonds are required. Fed has no control on Household's choice and it has no control over their excess reserves. First and third option should be selected.

Answer 2

(1)

Money multplier (m) = 1 / Reserve requirement (r)

Money supply = Deposit x m

(i) When r = 5% = 0.05

m = 1 / 0.05 = 20

Money supply = $300 x 20 = $6,000

(ii) When r = 10% = 0.1

m = 1 / 0.1 = 10

Money supply = $300 x 10 = $3,000

(2) Higher reserve requirement is associated with a Smaller money supply.

(3) When Fed wants to increase money supply by $200 and r = 10% (i.e. m = 10),

Fed will use open market operations to Buy $20 worth (= $200 / m = $200 / 10 = $20) government bonds.

(4) When r increases from 10% to 25%,

Increase in r causes money multiplier to fall to 4 (= 1 / 0.25). Under these conditions, Fed will have to Buy $50 worth (= $200 / m = $200 / 4 = $50) government bonds.

(5) Reasons why Fed cannot precisely control the money supply are:

- Fed cannot control whether and to what extent banks hold excess reserves (The more (less) excess reserves banks hold back, the lower (higher) the money supply).

- Fed cannot control the amount of money households choose to hold as currency (The higher (lower) the currency drainage, the lower (higher) the MM, and the lower (higher) the money supply)