Assume the banking system contains the following amounts: Total reserves $80 bil

Question

Assume the banking system contains the following amounts: Total reserves $80 billion Transactions deposits $800 billion Cash held by public $100 billion Reserve requirement 0.10

a) Are the banks fully utilizing their lending capacity?

b) What would happen to the money supply initially if the public deposited another $30 billion of cash in transactions accounts?

Decrease by $30 billion

c) What would the lending capacity of the banking system be after such a portfolio switch?

Instructions: Enter your responses as a whole number.

$  billion

(d) How large would the money supply be if the banks fully utilized their lending capacity?

$  billion

(e) What three steps could the Fed take to offset that potential growth in M1?

Explanation / Answer

a) Are the banks fully utilizing their lending capacity?

In this situation banks are fully utilizing their lending capacity. $80 billion of reserves are required at the required reserve ratio of 0.10. This is calculated as $800 billion in deposits × 0.10. Thus, there are no excess reserves, and banks are fully utilizing lending capacity.

b) What would happen to the money supply initially if the public deposited another $30 billion of cash in transactions accounts?

Assuming this $20 billion cash is not new money in the system—in other words, it is part of the $100 billion in cash currently being held—then there will be no change in M1.

c) What would the lending capacity of the banking system be after such a portfolio switch?

After the additional deposit of $20 billion in cash, now required reserves are $820 billion × 0.10 = $82 billion, and total reserves will initially be $100 billion. Now, therefore, there are excess reserves of $100 billion – $82 billion = $18 billion. The lending capacity of the banking system is now $18 billion × 10 = $180 billion. The money multiplier is 1 / RR = 1 / 0.10 = 10

d) How large would the money supply be if the banks fully utilized their lending capacity?

Assuming the lending capacity of $180 billion is fully used, the money supply will rise to $1,080 billion, or $1.08 trillion. This consists of the current $820 billion in transactions deposits, $80 billion in cash remaining after the deposit was made, plus $180 billion in new money created through the lending process.

e) What three steps could the Fed take to offset that potential growth in M1?

To offset the potential growth in M1 illustrated in (e), the Fed could increase the reserve requirement, raise the discount rate, or sell bonds in the open market

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