Question

Assume that the following data describes the current condition of the commercial banking system. Total reserves: $80 billion . Transaction deposits: $650 billion

Cash held by public: $200 billion
Required reserve ratio: 0.10

A. How large is the money supply (M1)?

B. How large are excess reserves?

Now assume that the public transfers $30 billion in cash into transactions accounts.

C. What would happen to the money supply initially(before any lending takes place)? Assuming the $30 billion in cash is not new money in the system, M1 will ____?

D. How much would the total lending capacity of the banking system be after this portfolio switch?

E. How large would the money supply be if the banks fully utilized their lending capacity?

Answer 1

A. To calculate the money supply (M1), we need to consider the components of M1, which include currency held by the public (cash) and demand deposits (transaction deposits). The formula for calculating M1 is:

M1 = Currency + Demand Deposits

Given:
Currency held by the public = $200 billion
Transaction deposits = $650 billion

M1 = $200 billion + $650 billion
M1 = $850 billion

Therefore, the money supply (M1) is $850 billion.

B. Excess reserves are calculated by subtracting required reserves from total reserves:

Excess Reserves = Total Reserves - Required Reserves

Given:
Total reserves = $80 billion
Required reserve ratio = 0.10

Required Reserves = Transaction deposits * Required reserve ratio
Required Reserves = $650 billion * 0.10
Required Reserves = $65 billion

Excess Reserves = $80 billion - $65 billion
Excess Reserves = $15 billion

C. When the public transfers $30 billion in cash into transactions accounts, the total reserves of the banking system increase by $30 billion (since the cash held by the public becomes part of the banks' reserves). However, the required reserves increase by 10% of the additional $30 billion. This is because the required reserve ratio is 0.10.

Increase in Required Reserves = Additional cash * Required reserve ratio
Increase in Required Reserves = $30 billion * 0.10
Increase in Required Reserves = $3 billion

The net effect on the money supply (M1) before any lending takes place would be a decrease of $3 billion. This is because the increase in reserves is partially offset by the increase in required reserves.

D. The total lending capacity of the banking system would be the increase in total reserves, which is the additional cash transferred into transactions accounts by the public:

Total Lending Capacity = Increase in Total Reserves
Total Lending Capacity = $30 billion

E. If the banks fully utilized their lending capacity, the money supply (M1) could increase by the same amount as the total lending capacity. Therefore, if the banks lend out the entire $30 billion, the money supply would increase by $30 billion. The new money supply would be:

New Money Supply = Initial Money Supply + Total Lending Capacity
New Money Supply = $850 billion + $30 billion
New Money Supply = $880 billion