Aa Aa 3. The reserve ratio, open-market operations, and the money supply Assume

Question

Aa Aa 3. The reserve ratio, open-market operations, and the money supply Assume that households do not hold currency, so the only form of money is demand deposits. Because there is no reserve requirement in Canada, banks are free to choose the percentage of demand deposits they will keep as reserves, which will henceforth be called the reserve percentage. (Note: This is just the reserve ratio expressed as a percentage.) Suppose the banking system has total reserves of $100 billion. Find the money multiplier and the money supply for each reserve percentage listed in the following table Money Supply Money multiplier(Demand Deposits) Percentage Held as Reserves 20% 25% For a given level of reserves, a higher reserve percentage is associated with a money supply Suppose the Bank of Canada wants to increase the money supply by $80 billion. Again, you can assume that households do not hold currency. If the reserve percentage is 25%, the Bank of Canada will use open-market operations to worth of Canadian government bonds. Now, suppose that-due to uncertain economic conditions-Canadian banks increase the percentage of deposits held for reserves from 25% to 50%. This increase in the reserve ratio causes the money multiplier to the Bank of Canada would need to money supply by $80 billion. to . Under these conditions worth of Canadian government bonds in order to increase the

Explanation / Answer

1. Money multiplier = 1/Required reserves = 1/0.20 = 5

Money supply = Money multiplier x Reserves = 5 x 100 billion = $ 500 billion

2. Money multiplier = 1/0.25 = 4

Money supply = 100 billion x 4 = $ 400 billion

3. Higher reserve requirement means lower money supply

4. Buy; $ 20billion worth of securities

MS = 20 billion x multiplier = 20 billion x 4 = $ 80 billion increase in MS

5. Multiplier 1 = 1/0.25 = 4

Multiplier 2 = 1/0.5 = 2

So, increase in Reserve ratio causes decrease in multiplier to 2.

6. Buy; $ 40 billion

MS = 40 billion x 2(multiplier) = $ 80 billion

7. The Bank of Canada cannot control the amount of money that households choose to hold as currency.

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