Suppose the commercial banks keep no excess reserves, and people deposit all mon
ID: 1216738 • Letter: S
Question
Suppose the commercial banks keep no excess reserves, and people deposit all money they receive into the banking system. Suppose the required reserve ratio is 0.2. Suppose the Federal Reserve wants to increase the monetary base by $1,000,000. How will the Fed do this? Show how this will initially affect the balance sheet of Bank of America. Show how the money expansion process will affect the balance sheets of two more commercial banks, showing the change in the overall money supply at each step. How much did money supply change as a result of the Fed's actions. How much would money supply change as a result of the Fed's action if banks held an additional 5% of cash reserves? Now suppose that in addition to the 5% of additional bank reserves from part (e) we assume that individuals and firms hold 25% of their money in cash versus checking deposits, how much would money supply change as a result of the Fed's action?Explanation / Answer
(a) Fed can increase the monetary base by using expansionary monetary policy, by
- Engaging in open market purchase of federal securities, and/or
- By increasing required reserve ratio (higher than current level of 0.2), and/or
- By increasing discount rate.
(b) In Balance sheet of BankAm, Deposits (liabilities) will rise by $1,000,000 and Reserves (Assets) will rise by $1,000,000.
(c) Assume that there are two other banks: A and B.
Out of total reserves of $1,000,000, BankAm will keep $200,000 (= $1,000,000 x 0.2) as required reserves, and will lend out $800,000 (= $1,000,000 - $200,000).
As a result, Deposits (Liabilities) in Bank A will rise by $800,000 and Reserves (Assets) will rise by $800,000.
Out of total deposits of $800,000, Bank A will keep $160,000 (= $800,000 x 0.2) as required reserves and lend out $640,000 (= $800,000 - $160,000).
As a result, Deposits (Liabilities) in Bank B will rise by $640,000 and Reserves (Assets) will rise by $640,000.
Out of total deposits of $640,000, Bank B will keep $128,000 (= $640,000 x 0.2) as required reserves and lend out $512,000 (= $640,000 - $128,000).
(d) Money multiplier (MM) = 1 / Reserve requirement = 1 / 0.2 = 5
Total increase in money supply = Initial increase x MM = $1,000,000 x 5 = $5,000,000
Note: First 4 sub-parts are answered.
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