Suppose that the reserve requirement for checking deposits...

Suppose that the reserve requirement for checking deposits is 10 percent and that banks do not hold any excess reserves. a. If the Fed sells $\$$1 million of government bonds, what is the effect on the economy's reserves and money supply? b. Now suppose the Fed lowers the reserve requirement to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

Transcript

00:01 Question 9.

00:02 Suppose that the reserve requirement for checking deposits is 10%.

00:10 So we first calculate the money multiplier, which is 1 divided by 10 % equals to 10.

00:21 So the money multiplier is 10.

00:24 All right, question a, if the fat sells $1 million of government balance, what is the effect of the economy's reserves? and money supply.

00:37 So if we draw the t account for the first bank, the deposit here is 1 million and the reserve ratio is 0 .1, so the reserve is 0 .1 million, while the money it loans out is 0 .9 million.

01:00 So the total reserve of this economy is just 0 .1 million times the money multiplier.

01:12 So the answer is $1 million as total reserves.

01:17 The total money supply is the original money supply times money multiplier, which equals to $10 million.

01:29 Okay, question b, so what if now the reserve rate is 0 .05? so we can see that the account is the same on the right hand side, sorry, on the right hand side, while on the other hand, the reserve is .5, but the bank voluntarily wants to hold another 5 % of deposits as excess reserves.

02:05 So excess reserves, i will write it in red, is 0 .05 million.

02:15 So the money it can loan out to other agents in the economy is the same as the previous question.

02:23 So it is also 0 .9 million.

02:29 So why would the bank do so? because if the bank does not hold excessive reserve, they cannot deal with the situation of default...

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