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Question 1

“The money multiplier is necessarily greater than 1.” Is this statement true, false, or
uncertain? Explain your answer.(group1)

Solution 1


m = money multiplier
c = currency ratio
r = required reserve ratio
e = excess ratio

If r + e are greater than 1, m will be less than1. If r + e are less than 1, m will be
greater than 1. In conclusion, the answer is uncertain.

Question 2

“If reserve requirements on checkable deposits were set at zero, the amount of
expansion would go on indefinitely.” Is this statement true, false, or uncertain?
Explain. (group1)

Solution 2


R=the total amount of reserves in the banking system

RR=the total required reserves
ER=the excess reserves
r=the required reserve ratio
D=the amount of checkable deposits
We set checkable deposits at zero

So RR=r*D(=0)
The total amount of reserves equals excess reserve.
Because R=ER, ER do not make additional loans, so this ER do not lead to the
creation of deposits. Therefore, if the fed injects reserves into the banking system,
and they are held us excess reserves, there will be no effect on deposits or currency
and hence no effect on the money supply.

3. During the Great Depression years 1930-1933, the currency ratio c rose
dramatically. What do you think happened to the money supply? Why? (group2)

The money supply fell sharply because when currency ratio rose, there was a shift
from one component of the money supply (checkable deposits) with more multiple
expansion to another (currency) with less. Overall multiple deposit expansion fell,
leading to a decline in the money supply. A large increase in the currency ratio
(brought on by a fear of bank failures) caused the money multiplier to fall sharply.
Since the money supply is defined as the multiplier times the monetary base, the same
number of reserves and currency created less money during this period. The money
supply fell, even though the central bank did make an attempt to increase the
monetary base.

4. During the Great Depression, the excess reserves ratio e rose dramatically. What do
you think happened to the money supply? Why?(group2)

The money supply model predicts that when {ER/D} and {C/D} increase, the money
supply will fall. The rise in {C/D} results in a decline in the overall level of multiple
deposit expansion, leading to a smaller money multiplier and a decline in the money
supply, while the rise in {ER/D} reduces the amount of reserves available to support
deposits and also causes the money supply to fall.

5. Traveler’s checks have no reserve requirements and are included in the M1

measure of the money supply. When people travel during the summer and
convert some of their checking account deposits into traveler’s checks, what
happens to the money supply? Why? (group 3)
Ans: The money supply will increase.
The reason is that Check deposits include promissory notes, certified checks and
traveler's checks and formula M1 is equal to Currency in circulation plus Checkable
M1= currency+ checking deposit+ saving deposit = C+D
C=Currency in circulation
D= Checkable deposits
The question states that checking account deposits convert into travel’s checks, so
checkable deposits will increase. Checkable deposits increase so money supply
will increase.

6. If Jane Brown closes her account at the First National Bank and uses the
money instead to open a money market mutual fund account, what happens to
M1 and M2? Why?

M1 remains unchanged. When Jane’s funds go to the money market mutual

fund, they are first deposited in the mutual fund’s bank account, leaving
reserves in the banking system unchanged. Because money market mutual
funds are not subject to reserve requirements, required reserves are unchanged
and the amount of deposits will remain unchanged if depositor ratios remain
unchanged. M1 thus remains unchanged.

7. Some experts have suggested that reserve requirements on checkable deposits

and time deposits should be set equal because this would improve control of
M2.Does this agrument make sense? (hint: think about what happens when
checkable deposits are converted into time deposits or vice versa.)

Yes, because with no reserve requirements on time deposits, a shift from

checkable deposits (with more multiple expansion) to time deposits (with
more multiple expansion) increases the total amount of deposits and raises
M2. However, if reserve requirements were equal for both types of deposits,
they would both undergo the same amount of multiple expansion, and a shift
from one to the other would have no effect on M2. Thus control of M2 would
be better because random shift from time deposits to checkable deposits or
vice versa would not affect M2.

8. Why might the procyclical behavior of interest rates (rising during business
cycle expansions and falling during recessions) lead to procyclical movements
in the money supply?

The rise in interest rates in a boom increases the cost of holding excess
reserves and the incentives to borrow from the Fed. Therefore, e falls, which
increases the amount of reserves available to support checkable deposits, and
the volume of discount loans increases, which raises the monetary base. The
result is a higher money supply during a boom. Similarly, when interest rates
fall during a recession, the money supply also has a tendency to fall because e
rises and the volume of discount loans falls.

9. The Fed buys $100 million of bonds from the public and also lowers r. What will
happen to the money supply?(group4)

Ans. Money supply will increase.

When Fed buys $100 million of bonds from the public, it also releases $100 million
currency to the public. We assume r is required reserve rate. When the Fed lowers r,
the bank can keep less money and release more money to the public. So we expect
money supply will increase in the future.

10. The Fed has been discussing the possibility of paying interest on excess reserves.
If this occurred, what would happen to the level of e? (group4)

Ans. The level of e will increase

When the Fed pays interest on excess reserves, the banks are more willing to have
more excess reserves. According to the equation above and assume D is fixed, when
the ER increase, the level of e will increase.
(We assume D will be fixed because paying interest on excess reserve from the Fed to
the banks will not affect the willingness of people to save their money)

11.IF the Fed sells $1 million of bonds and banks reduce their borrowings from the
Fed by $1 million, predict what will happen to the monet supply. (group5)
With the nonborrowed monetary base MB unchanged, more Discount loans from
the Fed provide additional borrowed reserves (and hence higher MB) to the banking
sys-tem, and these are used to support more currency and deposits. The result is : The
money supply is positively related to the level of borrowed reserves, BR, from the
Fed. In this question , the Fed reduce ,so the money supply will fall down ,too.
12. Predict what will happen to the money supply if there is a sharp rise in the
cunency ratio.

The money supply falls. The rise in c means that there has been a shift from deposits which
undergo multiple deposit expansion to currency which does not. Thus overall level of multiple
expansion declines, and the money multiplier and money supply fall.

13.What do you predict would happen to the money supply if expected inflation
suddenly increased?(group5)
When inflation increases, money supply will increase to meet the ever more
expensive price.

14. If the economy starts to boom and loan demand picks up, what do you predict
will happen to the money supply?

An increase in loan demand will cause the market interest rate to rise. Higher interest
rates will cause banks to reduce their excess reserves, leading to a decrease in e. A
lower excess reserve ratio suggests a larger money multiplier and an increase in the
money supply.

15. Milton Friedman once suggested that Federal Reserve discount lending (and
borrowed reserves) should be abolished. Predict what would happen to the
money supply if Friedman’s suggestion were put into practice. (group 3)

Ans.: The money supply will decrease.

Banks did not pass due bills discounted back to the Federal Reserve. The
discount lending is to buy notes, transferring funds. If the abolition of the discount
lending will reduce the transferring of funds, relatively money supply will reduce.
c +1
Ms=MB x m, m = because e↑, the m↓, than Ms↓
c+r +e