Question

Assume that a bank receives a cash deposit of $9,000 from a customer. What is the immediate impact of this transaction on the money supply? Explain. Suppose that the reserve requirement is 10 percent and banks voluntarily keep an additional 10 percent in reserves. Calculate each of the following. The maximum amount by which this bank will increase its loans from the transaction in part (a) The maximum increase in the money supply that will be generated from the transaction in part (a) Assume that the government increases spending by $9,000, which is financed by a sale of bonds to the central bank. Indicate what will happen to the money supply. Explain what will happen to the money demand.

Answer 1

Answer:

the money multiplier = 1 / reserve ratio

in this case, the reserve ratio is 10% (required) + 10% (voluntary) = 20%, so the money multiplier = 1/20% = 5

What is the immediate impact of this transaction on the money supply?

• None, since the money supply doesn't change. When a customer deposits money in a bank, the money does not increase, only its composition changes.

The maximum amount by which this bank will increase its loans from the transaction in part (a)

• the bank will be able to loan ⇒ total deposit x (1 - reserve ratio) = $9,000 x (1 - 20%) = $7,200

The maximum increase in the money supply that will be generated from the transaction in part

• since the banks started to "create" money by lending the money, the money supply will increase by ⇒ total deposit x (money multiplier - 1) = $9,000 x 4 = $36,000

Assume that the government increases spending by $9,000, which is financed by a sale of bonds to the central bank. Indicate what will happen to the money supply.

• The money supply will increase.

Explain what will happen to the money demand.

• The money demand will also increase because aggregate demand and income will increase. Aggregate demand will increase by ⇒ $9,000 x government multiplier. The government multiplier = 1 / MPS.