19. The reserve requirement, open market operations, and the money supply Aa Ass
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19. The reserve requirement, open market operations, and the money supply Aa Assume that banks do not hold excess reserves and that households do not hold currency-the only form of money is checkable deposits. Suppose the banking system has total reserves of $600 billion. Find the simple money multiplier and the money supply for each reserve requirement listed in the following table. Money Supply (Checkable Deposits) Reserve Requirement 10% 20% Simple Money Multiplier For a given level of reserves, a higher reserve requirement is associated with a money supply. Suppose the Federal Reserve (the Fed) wants to increase the money supply by $200 billion. Again, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 20%, the Fed will use open-market operations to worth of U.S. government bonds. Now, suppose that rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, in addition to the required reserves of 20%, banks hold an additional 5% of their deposits as reserves. This increase in the reserve ratio causes the money multiplier to would need to to Under these conditions, the Fed worth of U.S. government bonds in order to increase the money supply by $200 billion. Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the money supply? Check all that apply. The Fed cannot control the amount of money that households choose to hold as currency. The Fed cannot prevent banks from lending out required reserves. The Fed cannot control whether and to what extent banks hold excess reserves.Explanation / Answer
(1) Checkable deposits = Total reserves = $600 billion
Money multplier (MM) = 1 / Reserve requirement (RR)
Money supply = Deposit x MM
(i) When RR = 10% = 0.1
MM = 1 / 0.1 = 10
Money supply ($ Billion) = 600 x 10 = 6,000
(ii) When RR = 20% = 0.2
MM = 1 / 0.2 = 5
Money supply ($ Billion) = 600 x 5 = 3,000
(2) Higher reserve requirement is associated with Lower money supply.
(3) When Fed wants to increase money supply by $200 billion and RR = 20% (i.e. MM = 5),
Fed will use open market operations to Buy $40 Billion worth (= $200 billion / MM = $200 billion / 5 = $40 Billion) government bonds.
(4) When RR increases from 20% to 25%,
Increase in RR causes money multiplier to fall to 4 (= 1 / 0.25). Under these conditions, Fed will have to Buy $50 Billion worth (= $200 Billion / MM = $200 Billion / 4 = $50 Billion) government bonds.
(5) Reasons why Fed cannot precisely control money supply are:
- Fed cannot control amount of money households choose to hold as currency (The higher (lower) the currency drainage, the lower (higher) the MM and the lower (higher) the money supply)
- Fed cannot control whether and to what extent Banks hold excess reserves (The more (less) excess reserves banks hold back, the lower (higher) the money supply).
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