Assets Liabilities Total reserves: ________ Deposits: $500,000 Required reserves

ID: 1204074 • Letter: A

Question

Assets Liabilities

Total reserves: ________ Deposits: $500,000

Required reserves: $20,000

Excess reserves: $80,000

Loans: $ 400,000

Total Assets: $500,000 Total liabilities $500,000

1. By how much will the banking system be able to expand the money supply? What would be the money supply in the economy?

2. If the Fed increases the reserve requirement from your answer to part a to 10 percent, explain verbally and show numerically what will happen to:

required reserves?

excess reserves?

The size of money multiplier?

the money supply in the economy?

Total reserves = Required reserves + Excess reserves = $(20,000 + 80,000) = $100,000

(1) Required reserves ratio (RR) = Required reserves / Desposits = $20,000 / $500,000 = 0.04 or 4%

Money multiplier (MM) = 1 / RR = 1 / 0.04 = 25

So, $1 of deposits will increase money supply by $25.

$500,000 of deposits will increase money supply by $500,000 x 25 = $12,500,000

New money supply = Current money supply (whose value is unknown) + $12,500,000

(2) As RR rises from 4% to 10%,

(a) Required reserves will increase to $500,000 x 10% = $50,000 (by $30,000).

(b) Excess reserves will fall by $30,000 (assuming total reserves remain unchanged).

So, MM falls from 25 to 10.

(d) Increase in money supply = $500,000 x 10 = $5,000,000

So money supply falls by $(12,500,000 - 5,000,000) = $7,500,000