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Suppose that the reserve requirement for checking deposits is 10 percent and that banks do not hold any excess reserves. a. If the Fed sells $1 million of government bonds, what is the effect on the economy’s reserves and money supply? b. Now suppose the Fed lowers the reserve requirement to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

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Principles of Macroeconomics (Mind...

7th Edition
N. Gregory Mankiw
Publisher: Cengage Learning
ISBN: 9781285165912

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BuyFindarrow_forward

Principles of Macroeconomics (Mind...

7th Edition
N. Gregory Mankiw
Publisher: Cengage Learning
ISBN: 9781285165912
Chapter 16, Problem 8PA
Textbook Problem
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Suppose that the reserve requirement for checking deposits is 10 percent and that banks do not hold any excess reserves.

a. If the Fed sells $1 million of government bonds, what is the effect on the economy’s reserves and money supply?

b. Now suppose the Fed lowers the reserve requirement to 5 percent, but banks choose to hold another 5 percent of deposits as excess reserves. Why might banks do so? What is the overall change in the money multiplier and the money supply as a result of these actions?

Sub part (a):

To determine
The impact of selling of bonds on the money supply and reserves.

Explanation of Solution

The Federal Reserve is the central bank of the US economy, and it is usually known as the Fed. The Fed has the responsibility of keeping the economy controlled from the fluctuations, and it has to control the money supply of the economy through its monetary policies. When the purchase of the government bonds from the public takes place, it will provide the money to the public which will increase the consumption in the economy. As a result of the multiplier effect, the money supply in the economy will increase by the multiplier times.

It is given that the required reserve ratio of the checking accounts is 10 percent, which means that the multiplier value of the economy can be calculated as follows:

Money multiplier=1Reserve ratio=10.10=10

Therefore, the value of the money multiplier in the economy is 10

Sub part (b):

To determine
The impact of selling of bonds on the money supply and reserves.

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