Question

YOU

Suppose that the Federal Reserve has set a reserve requirement of 5 percent and that
banks will not hold any excess reserves.
a) How much will the money supply increase if the Federal Reserve purchases $2,000
worth of
government bonds from the public? Show your work.
b) How much will the money supply increase if James deposits in the bank $2,000 that
he had
been keeping under his mattress? Show your work.
2. Suppose that the Federal Reserve has set a reserve requirement of 10 percent and
that
banks will not hold any excess reserves.
a) If the Federal Reserve conducts open market operations and sells $1 million worth of
government bonds to the public, by how much will the money supply decrease? Show
your
work.
b) If the Federal Reserve lowers the reserve requirement to 5 percent, but all banks
decide to
hold an additional 5 percent of deposits as excess reserves, by how much will the
money supply
decrease if the Federal Reserve sells $1 million worth of government bonds to the
public? Show
your work.

Answer 1

Money Supply Changes under Different Scenarios:

1. Reserve Requirement of 5%:

a) Federal Reserve Purchases $2,000 Bonds:

1. Increase in bank deposits = $2,000

2. Required reserves = 5% * $2,000 = $100

3. Increase in loanable funds = $2,000 - $100 = $1,900

4. Assuming banks lend out all loanable funds, the money supply increases by $1,900.

b) James Deposits $2,000:

1. Increase in bank deposits = $2,000

2. Required reserves = 5% * $2,000 = $100

3. Increase in loanable funds = $2,000 - $100 = $1,900

4. Assuming banks lend out all loanable funds, the money supply increases by $1,900

2. Reserve Requirement of 10%:

a) Federal Reserve Sells $1 Million Bonds:

1. Decrease in bank deposits = $1 million

2. Required reserves decrease by 10% * $1 million = $100,000

3. Increase in loanable funds = $100,000 (decrease in reserves)

4. Assuming banks lend out all loanable funds, the money supply decreases by $900,000 (difference between decrease in deposits and increase in loanable funds).

b) Reserve Requirement Reduced to 5% with Excess Reserves

1. Federal Reserve sells $1 million bonds, causing a $1 million decrease in bank deposits.

2. Required reserves decrease by 5% * $1 million = $50,000.

3. Banks hold an additional $50,000 as excess reserves, leaving only $100,000 for loanable funds.

4. The money supply decrease is calculated as:

Decrease in deposits = $1 million

Increase in loanable funds = $100,000

Money supply decrease = $1 million - $100,000 = $900,000