Question

Suppose that with a fixed stock of $500 billion in base money, the money supply is $750 billion when the public’s currency-deposit ratio is 0.5. If, all at once, the banking system reserve ratio falls to half its original value, the velocity of money triples, and real output doubles, what, ceteris paribus, will happen to the price level? What could the Federal Reserve do to avoid any change in the price level?

Answer 1

Decline in the reserve ratio will reduce the amount of the required reserves and increase the amount of excess reserves of the bank. Thus, money supply which is the multiple amount of the excess reserve will increase. Increase in the velocity of money and real output will also shift the aggregate demand curve of the economy to right. Thus, price level in the economy will increase.

To avoid any change in the price level, The Fed should reduce the quantity of money supplied in the economy by selling government securities in the open market. This will shift the money supply curve leftwards and thus increase the level of interest rate and thus reduce investment level in the economy. Thus, aggregate demand will decloine and thus price level increase can be reduced.