Question

When a central bank increases bank reserves by $1, the money supply rises by more than $1. The amount of extra money created when the central bank increases bank reserves by $1 is called the money multiplier.
a. The money multiplier is generally greater than 1 because:

1. in a fractional-reserve banking system, each dollar bill is spent more than once (velocity is larger than 1), thereby increasing the money supply by more than $1.
2. in a fractional-reserve banking system, each dollar of reserves can support more than one dollar of deposits, thereby increasing the money supply by more than $1.
3. in a 100 percent reserve banking system, each dollar of reserves supports exactly one hundred dollars of deposits, thereby increasing the money supply by $100.
4. when a central bank increases bank reserves by $1, deposits are automatically increased by $1 as well, thereby increasing the money supply by $2.

The money multiplier is equal to 1 when:

1. reserves < deposits.
2. reserves > deposits.
3. reserves = deposits.

b. The initial money supply is $1,500, of which $700 is currency held by the public. The desired reserve-deposit ratio is 0.1. Calculate the increase in the money supply associated with increases in bank reserves of $10. What is the money multiplier in this economy? Assume that individuals do not change their currency holdings.

c. A general rule for calculating the money multiplier is:

1. 1/(deposit ratio-desired reserve).
2. 1/deposit ratio.
3. 1/desired reserve.
4. 1/(desired reserve-deposit ratio).

d. Suppose the Fed wanted to reduce the money multiplier, perhaps because it believes that change would give it more precise control over the money supply. In order to achieve its goal, the Fed would:

1. decrease the ratio of reserves to deposits.
2. increase reserve requirements.
3. increase the money supply.
4. decrease reserve requirements.

Answer 1

Answer: a. 2. in a fractional-reserve banking system, each dollar of reserves can support more than one dollar of deposits, thereby increasing the money supply by more than $1.

3. reserves = deposits.

b. $900.

Multiplier is 10

c. 4. 1/(desired reserve-deposit ratio).

d. 2. increase reserve requirements.

Explanation:

a. In fractional-reserve banking system, $1 of deposits can be used to create more than $1 in money supply as the money is continuously deposited into other bank accounts. This enables the money to keep increasing until it theoretically reaches a certain amount determined by the money Multiplier.

If the money Multiplier is equal to 1 which is a very rare occasion, this means that the amount required in reserves is equal to the deposits. $1 of deposits will yield a $1 in money supply increase.

b. The desired reserve-deposit ratio is 0.1. For every $1, 0.1 goes to reserves.

If bank reserves have increased by $10 then that means that deposits are,

0.1x = 10

x = $100

Deposits not in reserve are,

= 0.9 * 100

= $90

The money Multiplier can be calculated with the formula,

= 1/(desired reserve-deposit ratio)

= 1/0.1

= 10

Increase in money supply is therefore,

= $90 * 10

= $900

c. As earlier mentioned, option D is the general rule for calculating the money Multiplier.

= 1/(desired reserve-deposit ratio)

d. If the Fed increases the reserve requirement, the effect would be a reduction in the money supply because the denominator is now higher.

For instance, reserve requirement of 0.1 vs 0.2.

At 0.1, the money supply would be,

= 1/0.1

= 10

At 0.2, the money supply would be,

= 1/0.2

= 5

The higher the reserve requirement, the lower the Multiplier.