Question

Consider a system of banking in which the Federal Reserve uses required reserves to control the money supply (as was the case in the United States before 2008). Assume that banks do not hold excess reserves and that households do not hold currency, so the only money exists in the form of demand deposits. To further simplify, assume the banking system has total reserves of $300. Determine the money multiplier as well as the money supply for each reserve requirement listed in the following table.Reserve Requirement (Percent) Simple Money Multiplier Money Supply (Dollars)5 10 A higher reserve requirement is associated with a_______money supply.Suppose the Federal Reserve wants to increase the money supply by $200. Maintain the assumption 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_________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______Under these conditions, the Fed would need to______worth of U.S. government bonds in order to $ to increase the money supply by $200. 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. O The Fed cannot control the amount of money that households choose to hold as currency. O The Fed cannot prevent banks from lending out required reserves. O The Fed cannot control whether and to what extent banks hold excess reserves.

Answer 1

The money multiplier determines how much the money supply can expand based on reserve requirements. A higher reserve requirement means a lower money multiplier and hence a smaller money supply. The Fed's control over the money supply is not exact due to factors such as household currency holding and banks' management of excess reserves.

Step-by-step explanation:

The money multiplier formula is 1 divided by the reserve requirement. For a reserve requirement of 5%, the money multiplier is 1 / 0.05, which equals 20. If the total reserves are $300, then the money supply can be calculated by multiplying the total reserves by the money multiplier: $300 * 20 = $6,000.

For a reserve requirement of 10%, the money multiplier is 1 / 0.10, which equals 10. Thus, with total reserves of $300, the money supply would be $300 * 10 = $3,000.

A higher reserve requirement is associated with a lower money supply, because banks can lend out less money, which leads to less creation of new money through the lending process.

When the Federal Reserve wants to increase the money supply by $200 with a reserve requirement of 10%, they need to add to the reserves of the banks by an amount that, when multiplied by the money multiplier, equals $200. The Fed would therefore purchase $20 (calculated as $200 / 10) worth of U.S. government bonds in open-market operations to increase the monetary base, which in turn is magnified by the money multiplier.

If banks begin holding some excess reserves, they lend out less, hence the money multiplier decreases. An increase in the reserve requirement ratio from 10% to 25% reduces the simple money multiplier from 10 to 1 / 0.25 = 4. Consequently, to increase the money supply by $200 under these conditions, the Fed would need to buy more government bonds. It would need to purchase $50 worth of government bonds because the new multiplier is 4, hence $200 / 4 = $50.

The statements that help explain why the Fed cannot precisely control the money supply are:

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

The Fed cannot control whether and to what extent banks hold excess reserves.

The reason the Fed cannot prevent banks from lending out required reserves is because these are the minimum reserves that banks are mandated to hold and are not available for lending.