Question 8 Chapter 16 The reserve requirement, open market operations, and the money supply
Assume that banks do not hold excess reserves and that househo
... [Show More] lds 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) Simple Money Multiplier
Money Supply
(Dollars)
5 20 6,000
10 10 3,000
Points: 1 / 1
A higher reserve requirement is associated with a money supply.
Points: 1 / 1
Explanation: Close Explanation
The money multiplier is the reciprocal of the reserve ratio. Under the assumption that banks do not
hold excess reserves, the reserve ratio will be equal to the reserve requirement set by the Federal
Reserve. For a reserve requirement of 5%, the reserve ratio is 1/20, and the multiplier is, therefore,
20. When the multiplier is 20, a banking system with $300 in reserves can
support in demand deposits.
If the reserve requirement rises from 5% to 10%, the reserve ratio rises from 1/20 to 1/10, and the
multiplier falls from 20 to 10. At the higher reserve requirement, the banking system's $300 in
reserves supports in demand deposits.
For a given level of reserves, a higher reserve requirement is associated with a smaller money supply.
At the higher reserve requirement, banks must hold a larger fraction of their deposits as reserves. This
keeps more reserves away from the money creation process (it keeps new loans from being made,
which would lead to more deposits, which would lead to more loans, and so on). Therefore, the higher
the reserve requirement, the fewer demand deposits are generated in the money creation process
from a given change in reserves.
Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume that
do not hold currency. If the reserve requirement is
Explanation: Close Explanation
Uncertain economic conditions cause banks to hold some excess reserves, increasing the percentage of
deposits held as reserves from 10% to 25% and increasing the reserve ratio from 1/10 to 1/4. The
money multiplier falls from 10 to 4—the reciprocal of the new reserve ratio (1/4).
When banks hold additional reserves, the Fed will have to buy more bonds in order to increase the
money supply by a given amount. Specifically, an open-market purchase of $50 worth of bonds (rather
than $20) is now required to increase the money supply by $200. When the Fed buys $50 in
government bonds, demand deposits and bank reserves rise by $50. With the smaller multiplier, the
$50 increase in reserves will support an increase in the money supply of .
fall
buy $50.00
Explanation: Close Explanation
To increase the money supply, the Fed must buy government bonds. In order to pay for the bonds,
the Fed creates money. Its purchase of bonds puts the new money in the hands of the public.
Assuming that households do not hold cash, the new money will be placed in demand deposits with
banks.
At a reserve requirement of 10%, the money multiplier is 10. Therefore, the money supply will grow
by 10 times the initial increase in demand deposits from the Fed's open-market purchase. If the Fed
buys $20 worth of government bonds, demand deposits and bank reserves will rise by $20. The $20
increase in reserves will support an increase in the money supply of as banks lend
out the excess reserves generated by the Fed's purchase.
10%, the Fed will use open-market operations to
government bonds.
worth of U.S.
Points: 1 / 1
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 4 . Under these conditions, the Fed would need to
worth of U.S. government bonds in order to increase the money supply by
$200.
Points: 1 / 1
buy $20.00
Which of the following statements help to explain why, in the real world, the Fed cannot precisely control the
money supply? Check all 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 theamount of money that households choose to hold as currency.
Points: 1 / 1
Explanation: Close Explanation
For most of this problem, you should have assumed that households hold money only in demand
deposits and that banks do not hold excess reserves. A more realistic model of the banking system
would relax both of these assumptions. In practice, banks can hold any level of excess reserves that
they choose, much as households can hold as much currency as they like. Since the Fed cannot
precisely control the level of excess reserves or the fraction of money households wish to hold as
currency, it cannot precisely increase or decrease the money supply. It can get pretty close, however,
by monitoring the behavior of banks and households and adjusting monetary policy to reflect changes
in banks' preferences for excess reserves or households' preferences for currency. [Show Less]