Question

Assume that the following data describe the condition of the commercial banking 7. system: Total reserves: $ 80 billion Transactions deposits: $700 billion Cash held by public: $30o billion Reserve requirement: o.10 (a) How large is the money supply (M1)? (b) Are the banks fully utilizing their lending capacity? (c) What would happen to the money supply initially if the public deposited another $20 billion in cash in transactions accounts? (d) What would the lending capacity of the banking system be after such a portfolio switch? (e) How large would the money supply be if the banks fully utilized their lending capacity? (f) What three steps could the Fed take to offset that potential growth in Mi?

Answer 1

a) Money supply M1 = C + D = 300 + 700 = 1000 billion

b) No. Required reserves are 10% of 700 = 70 billion but total reserves are 80 billion so that 10 billion are excess reserves

c) Money supply initially increases by 20 billion because this additional 20 billion comes from outside the 300 billion held by public and that M1 = C + D

d) Now deposits are 720 billion and total reserves are 100 billion. This implies that required reserves are 72 billion and excess reserves are 28 billion. Hence lending capacity rises from 10 billion to 28 billion

e) Money multiplier = (1 + C/D)/(C/D + R/D) = (1 + 300/700)/(300/700 + 70/700) = 2.702703

Total increase in money supply = 20 * 2.702703 = 54 billion

f) To offset the growth in M1, Fed would raise discount rate, increase reserve requirement or sell government securities in open market.