v4-Monetary Policy

# 2 the bank shows a total of 2710 in demand deposits

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2. the bank shows a total of \$2710 in demand deposits (which are spendable) (your account \$1,000; the dry cleaner- \$900; the beer distributor- \$810) Thus at this point , the \$1000 you deposited has given rise to a money supply (M1) of \$2710! If we carried this example to its conclusion, assuming no excess reserves and that all loan proceeds are deposited, the original \$1,000 deposit would give rise to a money supply of \$10,000! The bank has, through this deposit expansion, taken \$1,000 in cash and created an additional \$9,000 in spending power! The Monetary Multiplier- similar to other multipliers we have studied, there is a multiplier at work in the example above. We can calculate the money supply resulting from an injection of new paper currency or new deposit without calculating out each subsequent loan and subsequent deposit. The formula for the monetary multiplier is the reciprocal of the required reserve ratio or: 1/required reserve ratio Using this formula, in the above example we calculate 1/10% or 1/.10 (how many times does a dime go into a dollar?). The multiplier here is 10. If we take the multiplier of 10 times the initial deposit of \$1,000 we see that the money supply will be \$10,000 (10 x \$1,000 = \$10,000). Remember, this assumes no excess reserves and that all loan proceeds are deposited. If the bank chooses to keep excess reserves (for whatever reason), the money supply will not grow by a factor of ten. Likewise, if any borrower chooses to take all or some of the loan in cash (say on the \$900 loan the dry cleaner takes \$50 in cash and deposits \$850 to his/her account), the money supply will not grow by a factor of ten. The same would be true if, originally, you decided to hold \$500 in cash and only deposit \$500. Excess reserves held by banks and "cash in the pocket" (or under the mattress!) are both considered cash leakages . These cash leakages reduce the monetary multiplier in the real world! The Fed and Monetary Policy Monetary policy seeks to regulate economic activity by changing the amount of the money supply. The goal of monetary policy is to help the economy attain a full employment level of output (Q f ) with a stable price level. Facilitating economic growth is also an objective.

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The Fed has three major monetary policy tools: 1. The Reserve Ratio- the Fed can change the reserve ratio, and thereby change the money supply created through deposit expansion (as discussed above). For example, if the Fed were to change the required reserve ratio from 10% in our example above to 20%, it would reduce the monetary multiplier from 10 to 5 (1/.10 versus 1/.20). Thus, if the required reserve ratio were 20%, your initial \$1,000 deposit would only give rise to a money supply of \$5,000 (assuming no cash leakages). Assuming no cash leakages, the Fed could reduce the money supply from \$10,000 to \$5,000 by increasing the required reserve ratio from 10% to 20%. The required reserve ratio is a very powerful tool in monetary policy but not very practical. It would not be practical for the Fed to shrink the money supply by a large move in the required reserve ratio, say from 10% to 20%. Think of it this way:

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