2. You graduate from Trinity as an Economics major and decide to work for the Bo

Question

2. You graduate from Trinity as an Economics major and decide to work for the Board of Governors of the Federal Reserve. Here is the balance sheet of the consolidated banking system of the country (all entries are in millions): Consolidated Balance Sheet of the Entire U.S. Economy Deposits Borrowing from Fed 50 700 Cash in Vault Deposits at Fed 30 4 Total Reserves 70 Bonds Loans 100 580 Total Assets 750 Total Liabilities 750 Assume that 1) households hold no currency and 2) banks hold no excess reserves The current reserve requirement is 10%. a. Under our assumptions, what is the money multiplier? Your boss, Janet Yellen, seeks your advice about monetary policy. For each part (b)-(d) below i) Conceptually explain the effect of the policy on the money supply. ii) Calculate the change in M1 given our assumptions. ii) Construct the new balance sheet of the consolidated U.S. banking system under the new policy iv) Predict what happens in the Aggregate Demand/ Aggregate Supply framework due to the change in M. Explain the chain of events carefully Then, using the Aggregate Demand /Aggregate Supply framework, determine v) the short run effect on the price level and real output and vi) the long run effect on the price level and real output vii) the total effect of the policy on the price level and real output b. Suppose that the Federal Reserve decreases the reserve requirement to 5%, c. Suppose that the Fed performs an open market operation and buys $10 million in bonds. d. Suppose that the Fed performs an open market operation and sells $10 million in bonds.

Explanation / Answer

a. Money Multiplier

Formula - 1 / Required Reserve Ration

Required Reserve Ration - 10%

Hence Money Multiplier - 1/10% = 10

i. Effect of policy on money supply

The multiplier effect is the expansion of a country's money supply that result ability of bank to lend. The size of the multipier effect depend on the percentage of deposite bank require to kept as reserve. To calculate the effect of the multiplier effect on the money supply; assume that bank take deposit of $100 and reserve requirement % is 10% then bank require to keep $10 as reserve and balance $90 will lend to customer. This $90 deposit by costumer in another bank then that bank also have to kept reserve 10% i.e. $ 9 and lend balance $81 and so on. This cycle is continue till initial deposit $100 create total deposit of $1000 ($100 / 10%). This creation of deposit is multiplier effect.

ii. Change in M1

M1 = 1+(C/D) / (rr + (ER/D) + (C/D))

C = Currency in circulatio = 0

D = Deposit = $700

rr = Required reserve ratio = .10

ER = Excess Reserve = 0

M1 = 1+(0/700) / (.10 +0/700 +0/700)

M1 = 10

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