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.