Question

Suppose that the Federal Reserve ("the Fed") buys $5,000 of U.S. government bonds and the required reserve ratio is 0.10. If the assumptions of the simple money multiplier hold, this will ________ the money supply by _______

Which of the following assumptions is necessary for the simple money multiplier to be applicable?
1. The amount of cash people want to hold doesn't change when the money supply changes.
2. People's marginal propensity to consume does not rise with income.
3. Borrower default rates are stable.

Answer 1

When the Fed buys $5,000 of U.S. government bonds with a reserve ratio of 0.10, it increases the money supply by $50,000 using the simple money multiplier. Assumptions needed include stable cash-holding behavior, unchanged marginal propensity to consume, and stable default rates, but macroeconomic factors can affect the actual outcome.

Step-by-step explanation:

If the Federal Reserve ("the Fed") buys $5,000 of U.S. government bonds and the required reserve ratio is 0.10, under the simple money multiplier model, this will increase the money supply by $50,000. The simple money multiplier effect implies that for every dollar of reserves, $1/required reserve ratio can be created in the banking system through a process of deposit creation and re-lending.

To apply the simple money multiplier, certain assumptions are necessary, including:

• The amount of cash people want to hold does not change when the money supply changes.People's marginal propensity to consume does not rise with income.Borrower default rates are stable.

With these assumptions, the multiplier effect remains predictable and stable. However, macroeconomic conditions and government rules can impact banks' behaviors, such as altering the amount of reserves held due to economic downturns or policy changes by the Federal Reserve.

Answer 2

If the assumptions of the simple money multiplier hold, this will INCREASE the money supply by $50,000.

The money multiplier = 1 / 0.1 = 10, so the increase in money supply = $5,000 x 10 = $50,000

Which of the following assumptions is necessary for the simple money multiplier to be applicable?

1. The amount of cash people want to hold doesn't change when the money supply changes.

One of the most serious problems with the money multiplier theory is that many of the assumptions that it requires do not always exist in real life. E.g. banks generally do not loan all the total loanable funds that they have. Or that debtors will spend all their credit immediately.