Question

Suppose that the reserve requirement for checking deposits is 20 percent and that banks do not hold any excess reserves. If the Fed sells $3 million of government bonds, the economy's reservesdecrease by $ million, and the money supply will by $ million. Now suppose the Fed lowers the reserve requirement to 15 percent, but banks choose to hold another 5 percent of deposits as excess reserves. True or False: The money multiplier will remain unchanged. True False True or False: As a result, the overall change in the money supply will remain unchanged. True False

Answer 1

Answer:

1. decrease, $ 3 million, decrease, $ 15 million

2. TRUE

3. TRUE

Explanation:

1. The reverse requirement is given as r = 0.2

The money multiplier is $\frac{1}{r}=\frac{1}{0.2}=5$

Now when the monetary base is changed by $3 million, then the total money supply will change by $\frac{3}{0.2}= \ 15 \ mn$.

Of the $ 15 mn, the reverse will change by $ 15 mn x 0.2 = $ 3 mn.

If Fed sells the government bond of $ 3 million, then the money supply will reduce and the economy's reverses will decrease by $ 3 million and the money supply will decrease by $ 15 million.

2. TRUE

   Now if the bank reduces the reserve ratio but he bank maintains excess reserves, then the money multiplier = $\frac{1}{(r+e)}=\frac{1}{0.15+0.05}=5$

Therefore, the money multiplier will remain same, it will remain unchanged.

3. TRUE.

Since the money multiplier remains constant, the overall change in money supply will not increase. It remains the same.