Question

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 $400. Determine the money multiplier and the money supply for each reserve requirement listed in the following table. 

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 _______ to  _______. Under these conditions, the Fed would need to  _______ worth of U.S. government bonds in order to increase the money supply by $200. 

Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply. 

• The Fed cannot control whether and to what extent banks hold excess reserves. 

• The Fed cannot prevent banks from lending out required reserves. 

• The Fed cannot control the amount of money that households choose to hold as currency.

Answer 1

Total reserves = $400

RR = 20%, Simple money multiplier = 100/20=5 and Money supply = 400*5=$2000

RR = 10%, Simple money multiplier = 100/10=10 and Money supply = 400*10=$4000

A Higher reserve requirement is associated with a Smaller money supply

Suppose the Fed wants to increase the money supply by 200 and RR is 10%. The Fed will use open market operations to buy 200*10% = $20 worth of bonds

Now, suppose, banks hold excess reserve and increase the RR from 10% to 25%.This increase in RR will cause the money multiplier to fall to 100/25 = 4 and under these conditions, the Fed will need to buy 200*25% = $50 worth of bonds to increase the money supply by $200

The Fed cannot precisely control the money supply because:

Option (A) and (C) are correct