Consider a simple economy in which money supply (think of M1) is determined through actions of the central bank, non-bank public, and commercial banks. Assume that the central bank influences the size of the monetary base and the public and commercial banks decide on the value of deposits and excess reserves.

i) Imagine that in a given point in time the value of the monetary base is equal to 100, the public chooses not to hold any currency, and commercial banks hold only required reserves, which are supposed to be equal to 10% of checkable deposits. What is the value of money supply in this case?

ii) Now, assume that commercial bank choose to hold excess reserves. Specifically, assume that they hold twice as much as they are required. What do you expect the money supply to be now?

iii) Now, assume that the public chooses to split their portfolios equally between currency and deposits. What is the value of the money multiplier in this case?

iv) Continue with assumptions of ii) and iii). What would be the instantaneous impact on money supply if the central bank engaged in a purchase of securities worth 10 through an open market operation?

Answer rating: 100% (QA)

Money Supply Determination i No excess reserves no public currency Monetary base 100 Required reserv... View the full answer