Assume that banks do not hold excess reserves and that households do not hold cu
ID: 1115626 • Letter: A
Question
Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $300. Determine the money multiplier and the money supply for each reserve requirement listed in the following table.
A higher reserve requirement is associated with a smaller money supply.
Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to buy worth of U.S. government bonds.
Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to fall to 4 . Under these conditions, the Fed would need to buy worth of U.S. government bonds in order to increase the money supply by $200.
Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply.
The Fed cannot prevent banks from lending out required reserves.
The Fed cannot control the amount of money that households choose to hold as currency.
The Fed cannot control whether and to what extent banks hold excess reserves.
Reserve Requirement Simple Money Multiplier Money Supply (Percent) (Dollars) 5 20 6,000 10 10 3,000Explanation / Answer
1) Solution: A higher reserve requirement is associated with a smaller money supply
Working:
Reserve requirement of 5%; the reserve ratio is 1/20; Multiplier is 20.
When the multiplier is 20, a banking system with $300 in reserves will own $6000 ( =$30*20) in demand deposits
Now when reserve requirement increases to 10%; multiplier reduces to 10; a banking system with $300 in reserves will own $3000 (=$30*10) in demand deposits
2) Solution: Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that banks do not hold excess reserves and that household do not hold currency. If the reserve requirement is 10%, the Fed will use open-market operations to buy $20.00 worth of U.S. government bonds.
Working: Reserve requirement of 10%; Multiplier is 10; When Fed buys $20 worth of government bonds, demand deposits and bank reserves will increase by $20
3) Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to fall to 4 . Under these conditions, the Fed would need to buy $50.00 worth of U.S. government bonds in order to increase the money supply by $200.
Working: With an increase in the percentage of deposits held as reserves from 10% to 25% and raising the reserve ratio from 1/10 to 1/4. The money multiplier declines from 10 to 4. With the smaller multiplier, the $50 increase in reserves will support a rise in the money supply of $200 (4*$50).
4) Solution:
-- The Fed cannot control whether and to what extent banks hold excess reserves
-- The Fed cannot prevent banks from lending out required reserves
-- The Fed cannot control the amount of money that households choose to hold as currency
Working: For majority cases there is an assumption that households hold money only in demand deposits and that banks do not hold excess reserves. Fed is not allowed precisely control the level of excess reserves or the fraction of money household wish to hold as currency. The Fed cannot prevent banks from lending out required reserves