3. If the reserve requirement (rr) is 0.2, what is the simple deposit multiplier

Question

3. If the reserve requirement (rr) is 0.2, what is
the simple deposit multiplier? If, in addition, the
currency deposit ratio (c) is 0.05 and the excess
reserve ratio (e) is 0.15, what is the money multiplier?
Explain why the money multiplier differs
from the simple deposit multiplier.

1. In current business publications or on the Federal
Reserve Web site (www.federalreserve.gov), find
the press release from the most recent meeting of
the FOMC. What is the targeted federal funds rate?
How does the FOMC evaluate the balance of risks
between its goals of price stability and sustainable
economic growth?

1. Describe how the following statements relate to
the AD–AS model:
a. The Fed has bought more than $2 trillion of
Treasury and mortgage bonds to stimulate the
economy.
b. The above actions by the Fed may cause inflation
to rise to levels that most would consider
unacceptable.
c. The Fed expected a weaker dollar to help increase
exports.
d. Businesses already have ample access to cheap
credit and are reluctant to borrow, hire, and invest
for other reasons.

Explanation / Answer

Reserve Requirement (rr) = 0.2

Deposit Multiplier = 1 / rr

Deposit Multiplier = 1 / 0.2 = 5

Curency Deposit Ratio (c) = 0.05

Excess Deposit Ratio (e) = 0.15

Money Multiplier (m) = (1 + c) / (rr + e + c)

m = (1 + 0.05) / (0.2 + 0.15 + 0.05)

m = 1.05 / 0.4

m = 0.42

The money multiplier measures the change in money (checkable deposits and currency) resulting from a given change in bank reserves. The term "multiplier" indicates that the change in money is inevitably a "multiple" of the initial change in bank reserves. However, the money multiplier differs from the simple deposit expansion multiplier (which is the inverse of the reserve requirement ratio) because banks are prone to keep some excess reserves and borrowers are inclined to transfer checkable deposits into currency held by them.

In theory, banks are motivated by the pursuit of profit to convert all excess reserves into loans, creating checkable deposits along the way. If they do, then the deposit expansion multiplier (and thus money multiplier) is equal to the inverse of the reserve requirement ratio. However, in practice, banks are often inclined to keep a few extra reserves. Here, the Fed has set the reserve requirement ratio at 0.2 or 20 percent, but banks realize they actually need an additional 15 percent. It is possible they need the extra reserve for their customers, in order to be able to effciiently conduct business. Keeping extra reserves limits the amount of checkable deposits and money created.

Borrowers are also inclined to convert checkable deposits into currency. In our example the currency deposit ratio is 5 percent, which does not have an immediate effect on the money supply. However, by removing deposits and reserves from the banking system, it does affect the deposit and money creation process, by limiting the amount of money created and the size of the money multiplier.

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