Suppose an economy’s Central Bank decides to purchase short term securities wort

Question

Suppose an economy’s Central Bank decides to purchase short term securities worth $20 billion from commercial bank dealers that it trades with in the open market. The monetary authority is expecting to influence the level of aggregate spending in the economy by $95 billion over the next 18 – 36 months. The reserve ratio is currently set at 12.5%, and the monetary authorities believe that banks are likely to lend at any time about 90% of their excess reserves, and can find borrowers at now reduced rates. Further, the authorities believe loan funds would be fully deposited by borrowers within the banking institutions. Assume nothing else goes wrong, and these beliefs hold true, would this action by the Central Bank be just about right, or be insufficient, or be too much. Explain, providing full computations and intuitive answers.

Explanation / Answer

The economy's central bank ecides to purchase short term seurities worth $20 billion from the commercial bank to inject money into the economy in terms of loans to the public. reserve ratio by the bank is 12.5% which is $2.4 billion. therefore total $17.5 billion money shall be availabe with the public. We assume general public demand the entire amount as loan from the commercial banks. So reserve ratio is 0.125 and ratio of cash balance with public cr is 0.10. so the money multiplier will be (1+cr)/(rr+cr)= (1+0.10)/(0.125+0.10)=4.8 The money multiplier tells us how much money in the economy change if a change in monetary base takes place.

So $20billion will result in 20*4.8= $96 billion aggregate spending in the nest 18-36 months. The action by the central bank to increase he aggregate spending by $95 billion is about right.

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