## Wednesday, December 7, 2016

### 2009 Macroeconomics FRQ #3

2009 Macroeconomics FRQ #3

(A) Assume that Kim deposits \$100 of cash from her pocket into her checking account. Calculate each of the following.

Refer to the Reserve Requirement Cheat Sheet here.

(i) The maximum dollar amount the commercial bank can initially lend.

So, Kim deposits her \$100 into the bank. The bank has to hold in reserves 20% of the \$100. So, \$20 is kept in reserve (it cannot be loaned out), which leaves \$80 that can be loaned by this commercial bank.

(ii) The maximum total change in demand deposits in the banking system.

This one confused me today,,, That tends to happen if you don't go over these questions regularly.

So, the change in demand deposits in the banking system. Demand deposit is the amount deposited into a bank and payable back to the customer upon demand. The whole \$100 is owed to Kim.

Excess reserves x money multiplier = max. change in loans
\$80 x 5 - \$400
Max. change in loans + original deposit = max. change in demand deposits
\$400 + \$100 = \$500

So, \$100 is deposited which makes demand deposits increase by \$100 and then money creation happens within the banking system.

How does that look????

This question is asking you how much money creation can happen throughout the banking system due to the deposit of \$100 by Kim, in the banking system. The 1st bank takes in Kim's \$100, keeps \$20 (20%) of it in required reserves, and loans out the remaining \$80. That money is then used and deposited into bank #2. Bank #2 takes the \$80 and keeps \$16 (20%) of it in required reserves and loans out the other \$64 dollars. That \$64 loan is spent and ends up in Bank #3 of which \$12.8 (20%) is required to be kept in reserve and the remaining \$51.2 is loaned out. Rinse, Repeat.

(iii) The maximum change in the money supply.

We can understand that the multiplier is 5.
How do we know this?
Check out the MPC/MPS Cheat Sheet here.

You can also use the formula 1/RRR and 1/.2 is 5. (the .2 is the 20%, required to be held in reserve)

So, Kim, deposits \$100 and 20% is held in reserve which means that \$80 can be loaned out and so on.

\$80 x 5 = \$400 ,,,,,,,

Understand that Kim's \$100 is not counted because it was already considered part of the money supply. So we just look at change in the money supply or just the new money created by the banks loaning out money.

(B) Assume that the Federal Reserve buys 5 million in government bonds on the open market. As a result of the open market purchase, calculate the maximum increase in the money supply in the banking system.

First, the FED has created \$5m and injected it into the money supply increasing the supply of money by \$5m immediately. Then the banks create money by loaning out the excess reserves.  The banks have \$5m deposited and their required reserves are \$5m x 20% or \$1m. Now banks have \$4m in excess reserves able to be loaned out by the banks. If they loan it all out, the \$4m is multiplied by 5 (just like above) which will give us \$20m.... oops!, don't forget to add to the \$20m the original \$5m that the FED invested into the money supply to get a total money supply increase of \$25m

(C) Given the increase in the money supply in part (b), what happens to real wages in the short-run. Explain.

If the money supply increases real wages fall as the value of every individual dollar someone holds will decline. We could also say that the prices of all goods will rise as more money chases the same amount of goods, pushing prices higher. If there are no wage increases to keep up with rising prices (inflation) then real wages have fallen.