3) The Fed purchases $2 million of T-bonds from Prudent Bank. Explan, using T-ac
ID: 1104793 • Letter: 3
Question
3) The Fed purchases $2 million of T-bonds from Prudent Bank. Explan, using T-accounts, what happens to reserves and the monetary base as a result of this transaction b) The reserve requirement(r) is 15%. Explain the next step for Prudent Bank after the change in reserves stemming from the Fed purchase of securities. Use a T-account to show your answer c) In the simple model of the money supply, how much does the overall money supply increase as a result of the Fed purchase of Treasury bonds? d) Let's add in some factors to our simple model of money supply determination. Assume c-0.4, e-0.005, and r is the same as above. In this more complicated set-up, how much does the overall money supply increase as a result of the Fed purchase of Treasury bonds?Explanation / Answer
Ans a - When the Fed purchases T bonds from banks there is an inflow of money into the bank which comes as an reserves for the bank. Hence the excess reserves of the bank will increase by the same amount of $2 million. As they are in excess reserves the bank will try to loan all of the money to the public.
Ans b - The bank will create $2 million in loans, the public to whom the loan is made available to will spend the money on goods and services. Through the multiplier process the money supply will increase by a multiple of $2 million.
Ans c - The multiplier is calculated as 1 / reserve ratio which in this case is 1 / 0.15 = 6.67. The money supply will increase by 2 x 6.67 = $13.33 million.
Ans d - c = currency ratio = 40%, e = excess reserve ratio = 0.5%
Money multiplier = (1 + 0.4) / (0.15 + 0.4 + 0.005) = 1.4 / 0.555 = 2.52
A one dollar increase in the monetary base will lead to a $2..52 increase in the money supply. Overall money supply increase will be = 2 x 2.52 = $5.05 million
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