2004 Macro FRQ #3 (FED Buys Bonds/ Reserve Requirements)

FED Buys Bonds (Money Supply)

So, lately I was stumped in class.

The 2004 Macro FRQ #3

A) As a result of the FED's action, what is the change in the money supply if the required reserve ratio is 100%??

Answer - If the RRR is 100%, the amount held by the bank in Required Reserves is all $5000 dollars. But  the thing is,, the FED dropped $5,000 into the market initially by buying the bonds. That is where the increase comes from (the initial purchase of bonds from the FED)

B) If the Required reserve ration is reduced to 10%, calculate the following.

(i) The maximum amount this bank could lend from this deposit.

If the required reserve is reduced to 10%, then that means the bank is required to keep in reserve 10% of the $5,000 dollars deposited. So .10 x 5,000 = $500 in Reserve

This means that $4,500 of the amount deposited is put in excess reserves that can be loaned out. 

Answer (i) - So, the maximum amount that can be loaned out from the initial deposit of $5,000 is $4,500.

The part below is where I had a bit of a brain-fart.

(ii) The maximum increase in the total money supply from the FED's purchase of bonds.

The maximum increase in the money supply is happening from two different actions.

1) The bank is able to loan out the $4,500 and that amount is multiplied throughout the economy. We calculate this as 1/RRR = 1/.1 = 10,, so the $4,500 x 10 = $45,000 increase in the money supply. This is the amount of money that the banks can increase the money supply by the deposit. BUT,, there is someone we forgot about.

2) The FED had increased the money supply by buying bonds from our friends at the Clark Consulting Service of $5,000. 

Answer - the maximum amount the money supply can be increased is $50,000,, $45,000 from the actions of the bank and $5,000 from the initial buying of bonds from Clarks.

C) If the bank keeps some of its excess reserves how will this influence the change in the money supply? 

Answer - if the banks don't use all of there excess reserves to loan out,, then the money supply will not be increased by as much as it could. It would be less than the $50,000 of maximum increase.

D) If the public decides to not put the cash into the banks how will this effect the money supply?

Answer - this is the same as question (C),, if people don't put their deposits in the bank,, then the money supply cannot be increased. If Clark had just kept the $5,000 in cash,, then the money supply would only have increased by $5,000,, no more.

College Board, I salute you.

Thanks, Jung-Sub