Unit 7Assignment
This section deals with increase money supply given two scenarios (see “a” and “b” below).
In Westlandia, the public holds 50% of money one (M1) in the form of currency, and the required reserve ratio is 20%.
Estimate how much the money supply will increase in response to a new cash deposit of $500 by completing the accompanying table.
(Hint: The first row shows that the bank must hold $100 in minimum reserves — 20% of the $500 deposit — against this deposit, leaving $400 in excess reserves that can be loaned out. However, since the public wants to hold 50% of the loan in currency, only $400 × 0.5 = $200 of the loan will be deposited in round 2 from the loan granted in Round 1.)
| Round | Deposits | Required reserves | Excess reserves | Loans | Loan proceeds held as currency | Loan proceeds deposited |
|---|---|---|---|---|---|---|
| 1 | $500.00 | $100.00 | $400.00 | $400.00 | $200.00 | $200.00 |
| 2 | $200.00 | $40.00 | $160.00 | $160.00 | $80.00 | $80.00 |
| 3 | $80.00 | $16.00 | $64.00 | $64.00 | $32.00 | $32.00 |
| 4 | $32.00 | $6.40 | $25.60 | $25.60 | $12.80 | $12.80 |
| 5 | $12.80 | $2.56 | $10.24 | $10.24 | $5.12 | $5.12 |
| 6 | $5.12 | $1.02 | $4.10 | $4.10 | $2.05 | $2.05 |
| 7 | $2.05 | $0.41 | $1.64 | $1.64 | $0.82 | $0.82 |
| 8 | $0.82 | $0.16 | $0.66 | $0.66 | $0.33 | $0.33 |
| 9 | $0.33 | $0.07 | $0.26 | $0.26 | $0.13 | $0.13 |
| 10 | $0.13 | $0.03 | $0.10 | $0.10 | $0.05 | $0.05 |
| Totals | $833.25 | $166.65 | $666.60 | $666.60 | $333.30 | $333.30 |
So, total increase in money supply (after 10 rounds) = Increase in loans = $600
| Round | Deposits | Required reserves | Excess reserves | Loans | Loan proceeds held as currency | Loan proceeds deposited |
|---|---|---|---|---|---|---|
| 1 | $500.00 | $100.00 | $400.00 | $400.00 | 0.00 | $400.00 |
| 2 | $400.00 | $80.00 | $320.00 | $320.00 | 0.00 | $320.00 |
| 3 | $320.00 | $64.00 | $256.00 | $256.00 | 0.00 | $256.00 |
| 4 | $256.00 | $51.20 | $204.80 | $204.80 | 0.00 | $204.80 |
| 5 | $204.80 | $40.96 | $163.84 | $163.84 | 0.00 | $163.84 |
| 6 | $163.84 | $32.77 | $131.07 | $131.07 | 0.00 | $131.07 |
| 7 | $131.07 | $26.21 | $104.86 | $104.86 | 0.00 | $104.86 |
| 8 | $104.86 | $20.97 | $83.89 | $83.89 | 0.00 | $83.89 |
| 9 | $83.89 | $16.78 | $67.11 | $67.11 | 0.00 | $67.11 |
| 10 | $67.11 | $13.42 | $53.69 | $53.69 | 0.00 | $53.69 |
| Totals | $2231.56 | $446.31 | $1785.25 | $1785.25 | 0.00 | $1785.25 |
So, total increase in money supply (after 10 rounds) = Increase in loans = $1785.25
c) What does this imply about the relationship between the public’s desire for holding currency and the money multiplier? Which scenario will contribute more to increase in money supply?
Therefore, as the public desires to hold more currency, money multiplier decreases. Scenario (b) contributes more toward creation of money supply.
Explain how each of the following changes quantity of money (money supply) in the economy.
| a. | the Fed buys bonds |
| b. | the Fed auctions credit |
| c. | the Fed raises the discount rate |
| d. | the Fed raises the reserve requirement |
a) When Fed buys bonds in exchange of cash, amount of cash at hands of public increases, in other words, money supply increases.
(b) The Fed auctions credit using the Term Auction Facility (TAF) using which, the Fed auctions specified amount of collateral-backed short term securities to financial institutions at a rate lower than discount rate. Since TAF is designed to create more liquidity, it increases money supply.
(c) When Fed raises discount rate, it becomes costlier for commercial banks to borrow money from Fed, and they raise their own lending rates. This decreases new credit and money supply decreases.
(d) A higher reserve requirement will compel commercial banks to set aside a higher portion from new deposits as required reserves, not available for commercial lending purposes. This will reduce new lending and money supply will reduce. (money decreases)
Assume that in a country the total holdings of banks were as follows:
| Amount in million dollars | |
| Required Reserve | $45 |
| Excess Reserve | $15 |
| Deposits | $750 |
| Loans | $600 |
| Treasury Bonds | $90 |
Show that the balance sheet balances if these are the only assets and liabilities.
Assuming that people hold no currency, what happens to each of these values if the central bank changes the reserve requirement ratio to 2%, banks still want to hold the same percentage of excess reserves, and banks do not change their holdings of Treasury bonds? How much does the money supply change by?
| Assets | amount | Liabilities | amount |
| Required reserves | $45 million | Deposits | $750 million |
| Excess reserves | $15 million | ||
| Loans | $600 million | ||
| Treasury Bonds | $90 million | ||
| Total Assets | $ 750 million | Total liabilities | $750 million |
|---|
If the Bank increases the reserve requirement ratio, the reserve would increase, and the amount loaned would decrease. The money supply would change by $1.20.
References
Mankiw, G. (2013).Principles of macroeconomics(7thed.). Stamford, CT: Cengage Learning.
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