In Westlandia, the public holds 50% of money one (M1) in the form of currency, a
ID: 1199853 • Letter: I
Question
In Westlandia, the public holds 50% of money one (M1) in the form of currency, and the required reserve ratio is 20%. a) Estimate how much the money supply will increase in response to a new cash deposit of $500 by completing the accompanying table. (Hint: The first row shows that the bank must hold $100 in minimum reserves — 20% of the $500 deposit — against this deposit, leaving $400 in excess reserves that can be loaned out. However, since the public wants to hold 50% of the loan in currency, only $400 × 0.5 = $200 of the loan will be deposited in round 2 from the loan granted in Round 1.) Round Deposits Required reserves Excess reserves Loans Loan proceeds held as currency Loan proceeds deposited 1 $500.00 $100.00 $400.00 $400.00 $200.00 $200.00 2 $200.00 3 4 5 6 7 8 9 10 Totals b) How does your answer compare to an economy in which the total amount of the loan is deposited in the banking system and the public does not hold any of the loans in currency? (Hint: Complete the table below when none of the loan proceeds held in currency following the example for row 1.) Round Deposits Required reserves Excess reserves Loans Loan proceeds held as currency Loan proceeds deposited 1 $500.00 $100.00 $400.00 $400.00 0.00 $400.00 2 $400.00 3 4 5 6 7 8 9 10 Totals c) What does this imply about the relationship between the public’s desire for holding currency and the money multiplier? Which scenario will contribute more to increase in money supply? 1) Explain how each of the following changes quantity of money (money supply) in the economy. a. the Fed buys bonds b. the Fed auctions credit c. the Fed raises the discount rate d. the Fed raises the reserve requirement 2) Assume that in a country the total holdings of banks were as follows: Amount in million dollars Required Reserve $45 Excess Reserve $15 Deposits $750 Loans $600 Treasury Bonds $90 Show that the balance sheet balances if these are the only assets and liabilities. Assuming that people hold no currency, what happens to each of these values if the central bank changes the reserve requirement ratio to 2%, banks still want to hold the same percentage of excess reserves, and banks do not change their holdings of Treasury bonds? How much does the money supply change by?
Explanation / Answer
answer1)
Total loan = 400+320+256+205.8+164.2....................
It is a geometric progression
total loan created = PD/reserve ratio
500/0.20 = 2500
How does your answer compare to an economy in which the total amount of the loan is deposited in the banking system and the public does not hold any of the loans in currency?
In such a case, loans can be generated upto infinity Primary deposits/0 = infinity
What does this imply about the relationship between the public’s desire for holding currency and the money multiplier? Which scenario will contribute more to increase in money supply?
It implies more will be the public's desire to hold currency, less will be the money multiplier and vice versa. When public desire to hold currency increases, money supply decrease and public's desire to hold currency decreases, money supply decreases.
1) Explain how each of the following changes quantity of money (money supply) in the economy. a. the Fed buys bonds
It increases money supply because bonds comes to fed and currency goes in the hands of general public.
b. the Fed auctions credit
Money supply increases as more and more people will get loans.
c. the Fed raises the discount rate
Demand for credit will decrease and hence money supply will decrease.
d. the Fed raises the reserve requirement
It is clear from the derivation above that more will be reserve requirement, less will be credt creation and vice versa.
2) Assume that in a country the total holdings of banks were as follows: Amount in million dollars Required Reserve $45 Excess Reserve $15 Deposits $750 Loans $600 Treasury Bonds $90 Show that the balance sheet balances if these are the only assets and liabilities. Assuming that people hold no currency, what happens to each of these values if the central bank changes the reserve requirement ratio to 2%, banks still want to hold the same percentage of excess reserves, and banks do not change their holdings of Treasury bonds? How much does the money supply change by?
Loans 600
reserves 45
excess reserves 15
treasury bonds 90
Initial Depostis Increase Derivative deposits Cash rserves Increase in loans Mathematically Round 1 500 - 100 400 Pd (1-reserve ratio) Round 2 - 400 80 320 Pd (1-reserve ratio)2 Round 3 - 320 64 256 Pd (1-reserve ratio)3 Round 4 - 256 51.2 205.8 Pd (1-reserve ratio)4 round 5 - 205.8 41.6 164.2 Pd(1-reserve ratio)5Related Questions
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