Econ%2B310%2BW2010%2BHW2%2BAnswers - Econ 310 Homework...

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Econ 310 Homework Assignment 2 Answer Key Question Four Use the money multiplier model from Chapter 14 to answer the following: (a) True or False: If the required reserve ratio were set equal to zero, then the multiple deposit expansion process would never end, and the money supply (M1) would be infinite. Explain. If instead you had used the simple multiple deposit creation model would your answer have been different? Does this alter the way you think about the simple multiple deposit creation model? (Question based on Mishkin, p 368, q 2). In the money multiplier model, the multiplier is m = (1+c)/(e+r+c). Even if r=0, m will not be infinite. Excess reserves and currency holding all represent “leakages” from the multiple deposit creation process, and so will limit the creation of deposits. On the other hand, if we looked at the simple deposit multiplier model, the multiplier in that case is m = 1/r, so if r=0 the multiplier in this case is infinite. This really just highlights how silly the simple deposit multiplier model is. It’s implausible that the money creation process from the banks would create an infinite amount of money. Even if required reserves were zero, banks would voluntarily hold reserves to back- up their deposits. And if they didn’t, then customers would be very foolish not to hold currency. In either case, we see banks or bank customers introducing a leakage from the deposit creation process that plays essentially the same role as required reserves in limiting money creation. (b) Interest rates are often observed to move pro-cyclically with the business cycle. What impact do interest rates tend to have on the money multiplier model of money supply determination? If interest rates do move pro-cyclically with the business cycle, would this suggest that the money supply would move pro- cyclically too? (Question based on Mishkin, p368, q8). If interest rates are high, this tends to discourage banks from holding excess reserves, as the opportunity cost of those funds is high (reserves don’t generate any interest at all). So, we expect that the excess reserve ratio will move counter-cyclically: in a boom period when interest rates are high, excess reserves are low. From the money multiplier model we know that a lower excess reserve ratio implies a larger money multiplier. So in boom periods, the money supply will tend to be higher. This tells us that the money supply would move pro-cyclically.
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(c) Use the money multiplier model to explain how the US money supply could shrink so dramatically during the Great Depression even though the money base remained roughly constant. Beginning around 1930, the bank system entered a period of extreme instability.
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This note was uploaded on 09/28/2010 for the course ECON 310 taught by Professor Hogan during the Winter '08 term at University of Michigan.

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Econ%2B310%2BW2010%2BHW2%2BAnswers - Econ 310 Homework...

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