Question

(b) The general public of Paula Island holds $688 million cash and there is excess reserve of $564 million in the country's banking system. The following table shows the current balance sheet of the banking system. Assets $ (million) 4,230 Deposits 23,970 28,200 Total Liabilities $ (million) 28,200 Reserves Loans Total 28,200 (i) Calculate the money supply (M1) and the required reserve ratio of the banking system of the country. Show your workings. (4 marks) (ii) Suppose the country is in the quick expansion stage of the economic cycle so the central bank decides to increase the required reserve ratio by 3% from the current ratio. At the same time, the general public withdraws $950 million from the banking system. Prepare a new balance sheet of the banking system of the county after it is fully loaned up. Show your workings. (4 marks) (c) Refer to question (b)(ii) above, identify the type of monetary policy the central bank conducts with the increase of the required reserve ratio. Explain how the money supply of the country will be affected. (4 marks)

Answer 1

M1 = coins and currency in circulation + checkable (demand) deposit + traveler’s checks

M1 = 688 + 28200 = 28888

Money multiplier = 1/reserve requirement

Current reserves in banking = 4230

Excess reserves = 564

Reserve ratio = (4230 - 564)/ 28200 = 13%

Increasing reserve ratio by 3% reduces liquidity.

New reserve ratio = 16%

General public withdraws 950 from banking system

Asset side

Deposits = 28200 - 950 = 27250

Liabilities side

Reserves @16% = 4360

Loans = 22890

The monetary policy in place is contractionary, increasing reserve requirement reduces liquidity.