The Central Bank and the Money Multiplier The small country of Emamade has a Cen
ID: 1197447 • Letter: T
Question
The Central Bank and the Money Multiplier The small country of Emamade has a Central Bank, which manages the money supply, and a single depository institution, the Emamade Credit Union. Alice and Bob are the only two residents of Emamade and both use the Emamade Credit Union for their deposits. The initial TAccounts for each of these institutions are given below:
All transactions in Emamade occur through checks so there is no currency ever in circulation. Additionally, the Credit Union never holds excess or insufficient reserves.
a) Given the information above, what is the monetary base (the monetary base is defined as the amount of reserves held by banks in this example) in this economy? What is the money supply, M2, where M2 consists of all currency in circulation plus demand deposits? Given this, what is the money multiplier for this economy?
b) Given the information above, what is the Credit Union’s reserve requirement?
c) Suppose that Alice decides to purchase a car from Bob’s car dealership for $50,000 (using a check). Write the new T-account for the Credit Union given this change. How does this change affect the Credit Unions assets? Does it now hold insufficient or excess reserves?
d) Return to the original scenario (before Alice purchased her car in part (c)). The Credit Union of Emamade is an especially responsible depository institution, and its depositors have a great deal of faith in its solvency. In light of this, the Central Bank decides to cut the Credit Union’s reserve requirement in half. Write the new T-account for the Credit Union assuming that Alice and Bob both benefit equally from the new loans the Credit Union provides. What is the new level of the money supply (M2)? What is the new money multiplier?
e) Given the change in part (d), how might you expect the aggregate demand curve of Emamade to react? What might you expect to happen in the short and long runs to prices and output?
f) Let’s again return to the original scenario (before the reserve requirement change). The Central Bank is now concerned that Emamade’s economy is performing below the long-run trend, and thus decides to increase Emamade’s monetary base to $400,000. What policy must the Central Bank undertake to get this new currency to the Credit Union? After undertaking such a policy, does the Credit Union hold insufficient or excess reserves? Write the new T-accounts for both the Central Bank and Credit Union based solely on the Central Bank's activity.
g) Given the result from (f), what will the Credit Union do to eliminate any insufficient or excess reserves? Write the new T-account for the Credit Union assuming again that the deposits of Alice and Bob are both adjusted equally.
Please help me go through this,... I did not learn this from lecture
Central Bank of Emamade Assets Liabilities T-Bills$200,000 Reserves $200,000 Emamade Credit Union Assets Liabilities Reserves T-Bills and other earning assets $200,000Alice's Deposits $800,000 $500,000 $500,000 Bob's DepositsExplanation / Answer
The monetary base or the reserves to be kept by the bank is 20%. As per the statement shown for the Bank, it has accepted deposits workth 1 Mn and kept reserves of 200K. Thus the share is 20%
Since there is no cash in the economy only the bank deposits which is 1Mn.
Money multiplier is the Initial Fund/reserve ration. The reserve ratio is 0.2, thus the multiplier is 5 i.e 1/0.2
Reserve requirement is 20%
d. The total deposit remains the same as the deposit moves from Alice to Bob. The T Bills and reserves remains the same only that Deposit of Alice is 450k and that of Bob becomes 550k
With the change in the reserve requirement there is no mention of change in the interest rate. thus there is no benefit to Alice and Bob for the loan. However with the reserve requirement becoming half the money multiplier will double.
WIth the extra funds available with the bank due to reduction in the reserve requirement the demand curve move up as there is more money to buy. The prices will go up as more people will be buying things.
f. To increase the monetary base to 400K from 200k, the reserve ratio needs to be doubled.
New money multiplier will be 1/0.4= 2.5
There is insufficient funds as the reserves needs to be increase. It will need to sell the investment and keep reserves
For Central Bank the reserves and T bills will become 400k
For the credit union, the Reserves will become 400k and TBills and other earning assets will be 600k
g Credit union will have to sell its T Bills for the funds.