BU204 02 Langhoff Melissa Unit7

Unit 7 Assignment
BU204_02

Melissa Langhoff

Unit 7 Assignment
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.

Answer: Deposits will increase by $833.25 and the loans will expand by $666.60 meaning that the supply of money will increase. The currency however will be about $333.30 after all 10 rounds.

(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 .41 1.64 1.64 .82 .82
8
.82 .16 .66 .66 .33 .33
9
.33 .07 .26 .26 .13 .13
10
.13
.03
.10
.10
.05 .05

Totals 833.25
166.65
666.60
666.60
333.30
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.)
Answer: Compared to the previous economy the deposits and the amount of currency in circulation would increase. The total deposits would increase by $1,398.32 compares to the previous chart and the proceeds would have increased by $1,451.96 at the end of the 10 rounds.
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 0 256.00
4
256.00 51.20 204.80 204.80 0 204.80
5
204.80 40.96 163.84 163.84 0 163.84
6
163.84 32.77 131.07 131.07 0 131.07
7
131.07 26.21 104.86 104.86 0 104.86
8
104.86 20.97 83.89 83.89 0 83.89
9
83.89 16.78 67.11 67.11 0 67.11
10
67.11 13.42 53.69 53.69 0 53.69

Totals
2231.57
417.31
1785.26
1785.26
0.00
1785.26

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?
Answer: The more money the public holds on to the lower supply of money. This will lead to a decrease in size of the money multiplier. Scenario B will lead to a increase in money supply because the public does not possess the currency.

2 Explain how each of the following changes quantity of money (money supply) in the economy.

a. the Fed buys bonds: This will increase the money supply because the Fed are purchasing bonds and providing more cash in to the economy.
b.
the Fed auctions credit: Auctioning credit allows banks to borrow money below the discount rate meaning that the money they borrow costs them less allowing them the ability to loan additional money to consumers.
c.
the Fed raises the discount rate: This will cause a decrease in the loanable money. This is because it will cost the banks more to borrow the money, increased costs to the banks mean not at much money offered.
d.
the Fed raises the reserve requirement: If the Fed were to raise the reserve requirements it will lead to banks being able to loan out less money because they must keep more of it due to the new regulations. Meaning there will be less money in circulation due to the increase.

3 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?
Answer: Deposits are the only liabilities and these total $750 million. The Assets equal $750 million, based on the combined total of reserves, loans and bonds. The balance sheet is balanced because both totals equal each other. With the reserve requirement lowered the financial institutions must retain $15 million leaving $30 million in excess funds. The banks are at a 4% reserve ratio because the required ratio is 2% and the banks wanted to match the 2% leading to 4% reserve ratio leading to $750 million additional deposits. $1500 million is the total deposits and half of this amount so $30 million is the Federal Reserve requirement the other $30 million is excess reserves meaning this additional money can be loaned to consumers. This means that the total assets will increase overall to 1500 million and the total liabilities will increase to 1500 million. The increase was $750 million in both liabilities and assets.

References: Mankiw, N. Principles of Macroeconomics. 7th Edition. Cengage Learning, 2015

References: Mankiw, N. Principles of Macroeconomics. 7th Edition. Cengage Learning, 2015