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Assume that the Bank of Ecoville has the following balance sheet and the Fed has

ID: 1220595 • Letter: A

Question

Assume that the Bank of Ecoville has the following balance sheet and the Fed has a 10% reserve requirement in place:

Balance Sheet for Ecoville International Bank

ASSETS

LIABILITIES

Cash

$33,000

Demand Deposits

$99,000

Loans

66,000

Required:

Now assume that the Fed lowers the reserve requirement to 8%.

If the money multiplier is 5, how much money will ultimately be created by this event?

If the Fed wanted to implement a contractionary monetary policy using reserve requirement, how would that work?

Balance Sheet for Ecoville International Bank

ASSETS

LIABILITIES

Cash

$33,000

Demand Deposits

$99,000

Loans

66,000

Explanation / Answer

(1) If reserve requirement is 8%, that means:

Excess reserves = $99,000 x (100 - 8)% = $99,000 x 92% = $91,080

Increase in total money supply = Excess reserves x Money multiplier = $91,080 x 5 = $455,400

(2) A contractionary monetary policy aims at lowering the money supply in the economy. Since

Increase in money supply = Increase in demand deposits / Reserve ratio,

Fed can lower money supply by increasing the required reserve ratio.