Question

Money Creation and Monetary Policy Tools

Assume the following: Initial deposit into a new bank of $15,000, the reserve requirement of 12%. Calculate the following:

a. List expansionary and contractionary monetary policy tools

b. Calculate the level of total Reserves, Required Reserves, and Excess Reserves - show all work or no credit will be given - which of the above represents the lending capability of the bank

c. Calculate the money multiplier when the reserve requirement is 12%? Show all work or no credit will be given.

d. Calculate the impact on the money supply of the bank fully loaning up - show all work

e, Calculate the impact on the money supply if the bank does not fully loan up but lends 80% of available funds - show all work

Answer 1

a) Monetary policies are the actions taken by central banks to control the monetary as well as financial status with the goal of attaining low inflation and sustainable growth in the economy. The techniques that are used by the central bank under monetary policies to alter the money supply include the reserve requirements, discount rate, and the open market operations.

--Reserve requirements refers to the portions of deposits that banks are required to hold in cash, either in their vaults or on deposit at a Reserve Bank. A fall in reserve requirements is expansionary because it raises the funds available in the banking system to lend to consumers and businesses. A hike in reserve requirements is contractionary because it decreases the funds available in the banking system to lend to consumers and businesses.

-- Discount rate refers to the interest rate that the Reserve Banks charge commercial banks for short-term loans. Lowering the discount rate is expansionary because it influences other interest rates. The lower rates will encourage lending and spending by consumers and businesses. In similar way, raising the discount rate is contractionary because the discount rate influences other interest rates. The higher rates will discourage lending and spending by consumers and businesses

--Open market operations (OMO) refers to the buying and selling of government securities in the open market for the purpose of expansion or contraction of the amount of money in the banking system, facilitated by the Federal Reserve (Fed). In the US the Federal Reserve when a central bank is interested in giving stimulus to the economy by increasing the money supply then, it purchases government bonds from commercial banks and the public. On contrary, when the central bank is interested in controlling inflation, it sells government bonds to the public and commercial banks.

-- Interest on reserves: When FOMC want to create a higher incentive for banks to lend their excess reserves, it can reduce the rate of interest it pays on excess reserves. Consequently the banks tend to lend money instead to hold it in reserve thus resulting to an expansionary policy. In a similar way, if FOMC want to reduce the bank's incentive to hold more excess reserves, it reduce the lending by increasing the interest rate paid on reserves, and leading to a contractionary policy

　

b) Total Reserves = Demand Deposits = $15,000

Required Reserves = [Total Reserves * Reserve Ratio] = [$15,000 * .12] = $1800

Excess Reserves = [Total Reserves - Required Reserves ] = [$15,000-$1800] = $13,200

　

c) Money Multiplier = 1/reserve requirement = [1/.12] = 8.33

　

d) Impact of Money Supply = [Excess Reserves * Money Multiplier] = [$13,200 * 8.33] = $109,956

　

e) [0.80($13,200) * money multiplier] = [$10,560 * 8.33] = $87,965