Macroeconomics Problem Set 4 By Dr. Robin Dhakal

Macroeconomicsproblem Set 4dr Robin Dhakalq1suppose You Deposit 2

Suppose you deposit $2,000 cash into your checking account. By how much will the total money supply increase as a result when the required reserve ratio is 0.2?

Suppose the reserve requirement is 15%. What is the effect on total checkable deposits in the economy if bank reserves increase by $40 billion?

Paper For Above instruction

The impact of deposit activities on the total money supply in an economy is primarily understood through the mechanism of the fractional reserve banking system. When an individual deposits money into a bank, only a portion of that deposit is kept as reserves, while the rest is lent out, creating potential for the expansion of the money supply through successive rounds of lending and re-depositing. This process is governed by the reserve requirement ratio, which determines the fraction of deposits that banks are mandated to hold as reserves.

Question 1 Analysis: Impact of a Single Deposit with a 20% Reserve Ratio

In the first scenario, an individual deposits $2,000 with a reserve ratio of 0.2 (or 20%). To determine how much the total money supply will increase, we employ the money multiplier formula, which is the reciprocal of the reserve ratio:

Money Multiplier = 1 / Required Reserve Ratio = 1 / 0.2 = 5

The total potential increase in the money supply is then calculated by multiplying the initial deposit by the money multiplier:

Total Increase = Initial Deposit × Money Multiplier = $2,000 × 5 = $10,000

Thus, a $2,000 deposit, under a 20% reserve requirement, can potentially lead to a $10,000 increase in the overall money supply through the process of fractional reserve banking.

Question 2 Analysis: Effect of Reserves Increase of $40 Billion with a 15% Reserve Requirement

In the second scenario, the reserve requirement is 15% (or 0.15). If bank reserves increase by $40 billion, the potential expansion of the money supply hinges on the money multiplier:

Money Multiplier = 1 / 0.15 ≈ 6.67

The maximum potential increase in checkable deposits resulting from the reserve increase is thus:

Total increase in checkable deposits = Increase in reserves × Money Multiplier = $40 billion × 6.67 ≈ $266.8 billion

Therefore, an injection of $40 billion into bank reserves, given a 15% reserve ratio, could lead to an approximate $266.8 billion increase in total checkable deposits, assuming that all banks lend out the maximum possible amounts without leakage or excess reserves.

Implications and Significance

These calculations exemplify the powerful role of fractional reserve banking in expanding the money supply and stimulating economic activity. Central banks regulate reserve ratios to control inflation and ensure financial stability, but the potential for monetary expansion is significant when reserve requirements are low. Conversely, higher reserve ratios tend to restrict growth, serving as a tool to temper inflationary pressures or prevent excessive risk-taking by banks (Mishkin, 2015).

Furthermore, the actual change in money supply depends on other factors, including banks’ willingness to lend, borrower demand, and regulatory constraints. The calculated multipliers provide a theoretical maximum under ideal conditions, highlighting the importance of central bank policies in managing economic stability.

Conclusion

Understanding how individual deposits and reserve changes influence the total money supply is fundamental to macroeconomic policy and banking operations. The examples demonstrate that a relatively small deposit or reserve change can have magnified effects on the economy, emphasizing the importance of reserve ratios and banking behavior in monetary policy design and economic stability management.

References

• Mishkin, F. S. (2015). The Economics of Money, Banking, and Financial Markets (10th ed.). Pearson.
• Cecchetti, S. G., & Schoenholtz, K. L. (2015). Money, Banking, and Financial Markets. McGraw-Hill Education.
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