Question

The reserve requirement, open market operations, and the moneysupply

Assume that banks do not hold excess reserves and that households 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 $500. Determine the money multiplier and the money supply for each reserve requirement listed in the following table.
Reserve Requirement Simple Money Multiplier Money Supply
(Percent) (Dollars)
25
10
A lower reserve requirement is associated with a______money supply.
Suppose the Federal Reserve wants to increase the money supply by $200. Again, you can assume 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 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?
A. The Fed cannot control whether and to what extent banks hold excess reserves.
B. The Fed cannot prevent banks from lending out required reserves.
C. The Fed cannot control the amount of money that households choose to hold as currency.

Answer 1

Answer: Please refer to Explanation

Step-by-step explanation:

The Money Multiplier is used to calculate how much money that a certain amount of bank reserves can supply given a certain Reserve Requirement.

The Money Multiplier is calculated by Dividing 1 by the reserve requirement.

1. a. Reserve Requirement of 25%

Money Multiplier = 1 / 25%

= 4

Money Supply = $500 * 4

= $2,000

b. Reserve Requirement of 10%

Money Multiplier = 1 / 10%

= 10

Money Supply = $500 * 10

= $5,000

c. A lower reserve requirement is associated with a higher money supply.

It is evident from the above that when the reserve requirement is lower, the money supply is higher.

2. The Fed buying Bonds means more money comes into the system. This means a change in money supply by the formula,

Change in Money Supply = Bonds purchased * Money Multiplier

Money Multiplier assuming 10% reserve requirement is 1/10% = 10

200 = Bonds Purchased * 10

Bonds Purchased = 200/10

= $20

The Fed will use Open Market Operations to buy Bonds of $20.

3. The Reserve Requirement increases to 25% so the new Multiplier will be,

= 1/25%

= 4

This increase in the reserve ratio causes the money multiplier to fall to 4.

4. Under these conditions, the Fed would need to_______worth of U.S. government bonds in order to increase the money supply by $200.

Change in Money Supply = Bonds purchased * Money Multiplier

200 = Bonds Purchased * 4

Bonds Purchased = 200/4

= $50

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

The Fed indeed cannot stop banks from holding excess reserves over the amount that they mandate as required reserves. Banks might decide that the Economy is not doing well enough to release funds.

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

The Fed as well cannot control how much households hold as currency. Households could choose to save more or less of their monies and it is entirely their own prerogative.