Assume that banks do not hold excess reserves and that households do not hold cu

Question

Assume that banks do not hold excess reserves and that households do not hold currency, so the only form of money is demand deposits. To simplify the analysis, suppose the banking system has total reserves of $300. Determine the money multiplier and the money supply for each reserve requirement listed in the following table Reserve Requirement (Percent) Money Supply Simple Money Multiplier(Dollars) 10 A higher reserve requirement is associated with a money supply Suppose the Federal Reserve wants to increase the money supply by $200. Aoain, you can assume that banks do not hold excess reserves and that households do not hold currency. If the reserve requirement is 10%, the Fed will use open market operations to w worth of U.S. government bonds Now, suppose that, rather than immediately lending out all excess reserves, banks begin holding some excess reserves due to uncertain economic conditions. Specifically, banks increase the percentage of deposits held as reserves from 10% to 25%. This increase in the reserve ratio causes the money multiplier to to Under these conditions, the Fed would need toworth of worth of U.S. government bonds in order to increase the money supply by $200. which of the following statements help to explain why, in the real world, the Fed cannot precisely ?0ntrol the money supply? Check ar that apply The Fed cannot control whether and to what extent banks hold excess reserves. The Fed cannot prevent banks from lending out required reserves The Fed cannot control the amount of money that households choose to hold as currency

Explanation / Answer

(A) When there are no excess reserves, Total reserves equal Deposits (= $300).

Money multplier (MM) = 1 / Required reserves ratio (RR)

Increase in Money supply = Increase in Deposit x MM

(i) When RR = 5% = 0.05,

MM = 1/0.05 = 20

Money supply = $300 x 20 = $6,000

(ii) When RR = 10% = 0.10,

MM = 1/0.10 = 10

Money supply = $300 x 10 = $3,000

(B) A higher reserve requirement is associated with a Lower money supply.

(C) When Fed wants to increase money supply by $200 and reserve requirement is 10% (i.e. RR = 0.1 and therefore, MM = 10),

Fed will use Open market operations to Buy $20 (= $200 / MM = $200 / 10 = $20) of US government bonds.

(D) When reserve requirement rises to 25% (i.e. RR = 0.25 and therefore, MM = 1/0.25 = 4),

Increase in required reserves ratio causes money multiplier to fall to 4 (= 1/0.25). Under these conditions, Fed would need to Buy $50 (= $200 / MM = $200 / 4 = $50) of US government bonds.

(E) Reasons why Fed cannot precisely control money supply are:

- Fed cannot control whether and to what extent Banks hold excess reserves

- Fed cannot control the amount of money households choose to hold as currency.

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