Suppose the current money stock in the economy is $1 billion, and the central ba

Question

Suppose the current money stock in the economy is $1 billion, and the central bank imposes each bank to hold at least 10% of deposits as reserves.

a. If people hold all the money as currency, what is the quantity of money in the economy?

b. If people hold all the money as demand deposits and banks maintain 10% reserve ratio, what is the quantity of money in the economy? 1

c. If people hold half of their money as currency and another half as demand deposits, and banks maintain 10% reserve ratio, what is the quantity of money in the economy?

d. Suppose people hold all the money as demand deposits and banks maintain 10% reserve ratio. If Fed sells $1 million of government bonds, what is the effect on the quantity of money in the economy?

e. If the Fed raises required reserves to 20% of deposits, what is the quantity of money in the economy?

Explanation / Answer

1. $1 billion

2. Money supply = 1/required reserve*excess reserve = 1/0.10*0.9 = $9 billions

3. Money supply = Currency in hand(0.5) + 1/required reserve*excess reserve =0.5 + 1/0.10*0.45 = 0.5 + 4.5

= $5 billions

4. Decrease in money base = $1000 millions - $ 1millions = $999 Millions = 0.999 billions

excess reserve = 0.999*.90 = 0.899

Money supply =  1/required reserve*excess reserve = 1/0.10*0.899 = $8.99 billions

5. Money supply = 1/required reserve*excess reserve = 1/0.20*0.9 = 4.5 billions

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