Deposits RRR = 12.5% Excess Reserves Loans Questions 1 – 4 are based on this tab

Question

Deposits

RRR = 12.5%

Excess Reserves

Loans

Questions 1 – 4 are based on this table

1. The government creates a brand new $1000. Fill in the missing data to trace what happens with that money.

2.   So far how much money is available in deposits to be spent?

3. Find the deposit multiplier.   

4.   What is the final maximum expansion of the money supply from the initial $1000?

5.   If the RRR fell to 10% what would be the new deposit multiplier and the new maximum expansion of the money supply from an initial $1000 money creation?

6.   Answer True or False for each of the following.

Keynes said speculative demand was the main reason people held money.

Most of M2 is banking money.

Savings accounts are more liquid than they used to be.

An increase in the money supply lowers interest rates.

Checks are a form of money.

     

7.   For each of the following state whether money demand rises or falls and if bank interest rates rise or fall.

Credit card use is reduced.

Average income falls.

Price level rises 3%.

Deposits

RRR = 12.5%

Excess Reserves

Loans

Explanation / Answer

Answers from 1-5:

Initial deposit = $1000.

Reserve requirement ratio = 12.5%

Required reserves = 12.5% of 1000 => 125.

This means that as RRR = 12.5%, with an dollar deposit in the bank, the bank is required to keep 12.5% of the deposit to itself and the remaining amount can be used up rather than keeping it idle.

So of $1000 deposited, $125 needs to be there with the bank in the form of cash which is the required reserve and the remaining 1000-125 = $875 can be spent. The bank can spend this amount in the form of providing loans to the borrowers and earn interest over it.

So, $875 are the excess reserves.

Maximum loan that can be provided is $875 or this $875 is the maximum amount that the bank can spend.

Deposit multiplier = 1/RRR.

Deposit multiplier = 1/12.5% => 1/ 0.125

Deposit multiplier = 8

Maximum expansion from the initial deposit of $1000 = (1/RRR)*$1000

(1/0.125)*1000 = $8000.

With an initial deposit of $1000 and RRR = 12.5%, the maximum expansion of money supply would be $8000.

Now if the RRR = 10%, Deposit multiplier = 1/RRR

Deposit multiplier = 1/0.10 = 10.

Maximum expansion of money supply in this case would be, (1/RRR)*1000

Money supply = (1/0.10)*1000 = $10,000. The lower the RRR, more will be the money supply with an initial deposit.

6. i) False.

Keynes gave three motives of why people hold money. This is also known as liquidity preference theory. Its because of transactionary motive, precautionary motive and speculative motive.All three are equally important coomponents of holding money.

ii)True.

M2 = M1 + saving account + money market accounts.

iii) True. An increase in money supply lowers the rate of interest. Interest rate acts as a stimulant between money demand and money supply, when supply increases with constant demand, to balance out the factor, interest rates fall.

iv). True. Cheques are form of money. Money has many forms apart from usual paper currency, credit cards, cheques, coins, gold, etc are also forms of money only.

7. As stated above, credit card is a form of money. If the use of credit card is reduced, the demand for money would rise, implyinh higher interest rates.

When average income falls, money demand would also fall and hence interest would fall too.

When price level rises, it implies that more money is needed to buy the same level of output, thus pushing the money demand upwards and hence the interest rates would also rise.

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