Question

Assume that the following data describe the current condition of the commercial banking system:

Value
Total reserves: $ 20 billion
Transactions deposits: $ 400 billion
Cash held by public: $ 300 billion
Required reserve ratio: 0.05
Instructions: Enter your responses as a whole number. In part b, round your response to one decimal place.

How large is the money supply (M1)?
$
billion

How large are excess reserves?
$
billion

Now assume that the public transfers $10 billion in cash into transactions accounts.

What would happen to the money supply initially (before any lending takes place)?
Assuming the $10 billion in cash is not new money in the system, M1 will
(Click to select)
.

How much would the total lending capacity of the banking system be after this portfolio switch?
$
billion

How large would the money supply be if the banks fully utilized their lending capacity?
$
billion

What three steps could the Fed take to offset this potential growth in M1?

(Click to select)
reserve requirements


(Click to select)
the discount rate


(Click to select)
bonds

Answer 1

Step-by-step explanation:

a) The money supply (M1) can be calculated as the sum of transactions deposits and cash held by the public, which is:

M1 = transactions deposits + cash held by public

M1 = $400 billion + $300 billion

M1 = $700 billion

Therefore, the money supply (M1) is $700 billion.

b) Excess reserves can be calculated as the difference between total reserves and required reserves, which is:

Excess reserves = total reserves - required reserves

Excess reserves = $20 billion - ($400 billion x 0.05)

Excess reserves = $20 billion - $20 billion

Excess reserves = $0 billion

Therefore, the excess reserves are $0 billion.

c) If the public transfers $10 billion in cash into transactions accounts, the money supply initially would not change, since the $10 billion in cash is not new money in the system. It is just a transfer from cash held by the public to transactions deposits, so the total amount of M1 remains the same.

d) The total lending capacity of the banking system can be calculated as the excess reserves multiplied by the money multiplier, which is:

Total lending capacity = excess reserves x money multiplier

Total lending capacity = $0 billion x (1/required reserve ratio)

Total lending capacity = $0 billion x (1/0.05)

Total lending capacity = $0 billion x 20

Total lending capacity = $0 billion

Therefore, the total lending capacity of the banking system is $0 billion.

e) To offset the potential growth in M1, the Fed could take the following steps:

Increase the reserve requirement ratio, which would reduce the amount of excess reserves and the money multiplier, limiting the amount of lending and the growth of the money supply.

Sell government securities on the open market, which would decrease the amount of reserves in the banking system, reducing the lending capacity and the potential for money supply growth.

Increase the discount rate at which banks can borrow from the Fed, which would increase the cost of borrowing and reduce the willingness of banks to lend, limiting the growth of the money supply.