Question

Let’s say the Federal Reserve buys $20 Billion in bonds from private banks:

*Total reserve requirement = 0.10 x $1Trillion = $100 Billion

• What is the total amount (in $) of reserves that banks can lend?
• Using the simple deposit multiplier, how much additional money (M1) is created by this process?
• What will happen to the Federal Funds Rate, the prime rate, and other nominal interest rates in the economy? (Go up, down, stay the same?) Why?
• If the price level stays the same, what will happen to real interest rates? (Go up, down, stay the same?)
• What effect will this policy have on investment? Why?
• What effect will this policy have on consumption? Why?
• Is this monetary policy or fiscal policy? Contractionary or expansionary? Explain.
• Thinking about the relationship between aggregate demand, short-run aggregate supply, and long-run aggregate supply:
  • When would this policy be appropriate? Explain.
  • When would this policy be inappropriate? Explain.

• Please study the table below:

  • Category	Value
    Total Reserves (private banks)	$100 Billion
    Currency (firms, households)	$50 Billion
    Value of Euros in the U.S. (private banks, firms, households)	$1 Billion
    Gov’t bonds (private banks, firms, households)	$30 Billion
    Demand deposits (private banks)	$1 Trillion
    Certificates of Deposit, CDs (private banks)	$10 Billion
    Reserve requirement on demand deposits                  =0.10

Answer 1

1.

Bank can lend $20 Billion ( because it has not come from deposit, rather bond as asset is exchanged with currency)

2.

Total money created by this process = 20/RRR = 20/.1

Total money created by this process = $200 Billion

3.

Federal Fund rate will decrease, as it is the part of expansionary monetary policy. It will lead the price rates and other nominal rates to decrease as well.

4.

Real interest will also decrease, because nominal interest rate is decreasing and price level remains same.

5.

Investment will increase, because more funds are available to the banks for disbursements to firms.

6.

Consumption level will also increase, because loans are available at lower interest rates. It will lead to increase in AD.

7.

It is a expansionary policy and it is a monetary policy.

8.

This policy will be appropriate, will economy is in recession, because economy needs a boost and stimulus to grow again. It happens when expansionary monetary policy is used.

9.

This policy will be inappropriate when economy is booming, because it will increase the inflation and price will become unstable.