Question

Question 3
Assume that the First National Bank (FNB) is the only commercial bank in the country, and it
always holds an excess reserve of 3%. Supposed that the required reserve is 5% and the Central
Bank purchases $100,000 worth of government bonds. Critically explain what will happen to
the money supply in the economy using FNB’s T-account. Please state all the important
assumption(s).

its a 10 mark question so please use diagrams and definitions where applicable **

Answer 1

Central bank in the country can influence the money supply by introducing new reserve requirements. If the reserve requirement is less than the banks will have more fund available to lend which leads to the increase in Money supply in the country.

So, if central bank wants reduce money supply then they can increase the reserve requirements.

There are various instrument that Central bank can use to control the money supply Market, One of the most common method is Open Market operations.

Open Market Operations: In Open Market operations Central bank buys goverment bonds from the banks and other suppliers which will increase money supply with the respective suppliers.

To Illustrate above Assume, First National Bank sold Goverment bonds worth $100,000 to central Bank let see below how it will impact the Money Supply.

Goverment Bond Value $100,000

Required reserve 5%

Excess Reserve 3%

Required Reserves= $100,000 X 5% = 5,000

Excess Reserve = $100,000 X 3% = 3,000

Total Reserves = $8,000

Assets	Liabilities
Reserves 8,000	Goverment Bonds 100,000
Loans 92,000

Here, FNB sold $100,000 Goverment Bonds to Central Bank which resulted in Excess Money with the FNB, Which now FNB can use for lending in the market out of $100,000 FNB needs to keep a Reserve of $8,000. Still it holds $92,000 worth of Assets to lend in the Market.

Govt. Bonds BANK Funds Loans Increase in Money Supply Due to Money flow in Market EA