2. Suppose Bob digs up a box in his front yard that contains $1000 . A) Would an

Question

2. Suppose Bob digs up a box in his front yard that contains $1000.

A) Would anything happen to the money supply (M1)? Explain

B) What would happen to the money supply when Bob deposits this in a bank (reserve-deposit ratio is .05)? What is the maximum amount of money that can be created? How does this occur?

3. A month later, Bob buys a $1000 government bond from the Fed with this money.

A) What happens to the money supply (M1)? Does it increase or decrease? By how much?

B) How would this impact Bob's future spending? Would it increase or decrease?

C) Under what circumstances would Bob be likely to buy bonds ? (describe the economy, his perceptions)

D) 5 years later Bob sells the bond for $1000 and buys $1000 in common stock. Describe the differences in Bob's investment portfolio. (how does it differ; what are the risks; what are his returns)

Explanation / Answer

(2)

(A) Money supply (M1) will increase.

The $1000 was hidden in the yard and therefore was not part of money supply, since it was not in existence until Bob found it out. This will increase cash & currency component of M1 by $1000, and so M1 will increase by $1000.

(B) A reserve deposit ratio of 0.05 (5%) means that for every $100 of new deposits, the bank has to set aside $4 as required reserves which it cannot lend, and can use the rest $95 for credit lending purposes.

When Bob deposits $1000 in bank 1, the bank keeps $50 ($100 x 5%) as required reserve and lends out $950 (= $1000 - $50). The person borrowing $950 deposits it in bank 2, which sets aside $950 x 5% = $47.5 as required reserves, and lends out $902.5 (=$950 - $47.5) as loans, and this process continues.

Eventually, total money supply increases by an amount equal to (Initial deposit / Required reserve ratio)

= $1000 / 0.05

= $20,000

NOTE: First question is answered.

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