Money, Banks and the Federal Reserve System
Money, Banks and the Federal Reserve System
1) 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%. a) Estimate how much the money supply will increase in response to a new cash deposit of $500 by completing the accompanying table.
| Round | Deposits | Required reserve | Excess reserves | Loans | Loans proceeds held as currency | Loans 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 |
The money supply increased by $666.60 after 10 rounds and from the table, it is shown by the total value of loans in circulation. Deposits increased by $833.25 and currency held by the public also increased by $333.30.
- b) How does your answer compare to an economy in which the total amount of the loan is deposited in the banking system and the public does not hold any of the loans in currency? (Hint: Complete the table below when none of the loan proceeds held in currency following the example for row 1.)
- 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?
| Round | Deposits | Reserve requirement | Excess reserves | Loans | Loans proceeds held as currency | Loans 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 | $2,231.57 | $446.31 | $1785.26 | $1785.26 | $0.00 | $1785.26 |
If the public does not hold any of the loans in currency, the money deposited will increase by $2,231.57 and the money supply will increase by $1,785.26.
When the public hold greater percentage of loans in currency, the money multiplier decreases in size. Therefore, the second scenario will contribute more to increase the supply of money.
2) Explain how each of the following changes quantity of money (money supply) in the economy
- The Fed buys bonds
When the Fed buy bonds from the public, the quantity of money in circulation will increase (Mankiw, 2013). The Fed will put money into the hands of the public by purchasing bonds from them.
- The Fed auctions credit
When the Fed auctions credit, the money supply in the economy will increase. If we have more funds available, the money supply will increase.
- The Fed raises the discount rate
Raising the discount rate reduces the money in circulation because the financial institutions will find it expensive to borrow from the Fed (Mankiw, 2013).
- The Fed raises the reserve requirement
When the Fed raises the reserve requirement, commercial banks will have to hold more reserves; therefore, they will lend out less money to the customer. This will reduce the money supply in the economy (Mankiw, 2013).
3) Assume that in a country the total holdings of banks were as follows:
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 | Liabilities |
| Required Reserves $45 million | Deposits $750 million |
| Excess reserves $15 million | |
| Loans $600 million | |
| Treasury bonds $90 million | |
| $750 million | $750 million |
When the Central Bank increases the reserve requirement ratio by 2%, the value of the Required Reserve will increase and this will reduce the amount loaned to the customers. The money supply will change by 1.02%.
References
Mankiw, G. (2013). Principles of macroeconomics (7th ed.). Stamford, CT: Cengage Learning.
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