Question

2. Let's assume that in a hypothetical economy currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, excess reserves are $15 billion and required reserve ratio is 10%. a. Calculate money supply, currency to deposit ratio, excess reserve ratio and money multiplier. b. Suppose Fed conducts very large open market purchase of $1400 billion due to a sharp recession. Assuming the ratios hold, what will be the effect on money supply? c. Now suppose the Fed conducts the same open market purchase as in part (b) except banks choose to hold all the proceeds as excess reserves. Assuming currency to deposit and required reserve ratios stay the same, what happens money multiplier and money supply? d. Can you draw parallels between part (c) and what happened during the financial crisis of 2008?

Answer 1

2a.)

Money Supply=currency + checkable deposit

= $600B + $900B

=$1500B

currency deposit ratio=currency/checkable deposit

=$600B/$900B

=66.7%

excess reserve ratio = excess reserves/checkable deposit

= $15B/$900B

=1.7%

Monetary Base = currency + total reserve

= $600B + $15B + $900B*10%

= $705B

Money Multiplier = Money Supply/Monetary Base

= $1500B/$705B

= 2.13

2b). The purchase of $1400B by Federal Reserves via open market operation will increase the monetary base by $1400B. With the money multiplier as 2.13, this will increase the money supply by $1400B*2.13=$2982B.

2c). Given that Fed conducts the open market purchase and that bank holds all of these proceeds as excess reserves rather than loaning them due to fear of financial crisis, the excess reserves with the banks = $15B+$1400B=$1415B

The excess reserve ratio=$1415B/$900B

=157.22%

The money supply=$600B+ $900B=$1500B

The monetary base=$600B+$1415B+$900B*10%

=$2105B

The money multiplier= money supply/monetary base

=0.71

2d). During the financial crisis, the federal reserves injected massive amount of liquidity in the banking system. But, banks chose to maintain them as reserves rather than create new loans out of them. As the result of the this, the money supply M1 multiplier remain less than 1 for most of the period between October 2008 and through 2011. The calculation shown in 2c). shows this situation.