ECON 304 Exam 2 Prep

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Pennsylvania State University, World Campus *

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304

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Economics

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Jan 9, 2024

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Economics 304 Lesson 07 to 09 1. What is the equation for the ‘more realistic’ money multiplier? Mm=[(C/D) + 1] / [C/D + RR/D + ER/D] = [cu + 1] / [cu + res ] 2. In the economy, the following statistics describe the money supply: C = $500b R = $125b D = $2,000b Given these data, calculate the following to whole numbers unless noted otherwise: Monetary Base ( BASE ): BASE = C + R = 500 + 125 = 625 B BASE = Money Supply ( M ): M = C + D = 500 + 2000 = 2500 M = Ratio of reserves to deposits ( res ): (carry out to four decimals) Res = R / D = 125/2000 = 0.0625 res = Ratio of currency to deposits ( cu ): (carry out to four decimals) Cu = C / D = 500/ 2000 =0.25 cu = Money Multiplier ( mm ): (carry out to four decimals) 625B 2500 B 0.0625 0.25 1

Economics 304 Lesson 07 to 09 Mm= (cu + 1) / (cu + res) = 1.25 / .3125 = 4 mm = Now suppose a shock causes banks to change the amount of reserves they hold relative to deposits so that res changes to 0.0750. Suppose that when this happens, both cu and BASE do not change. However, the change in res will affects mm , M , C , R , and D . Calculate the following: Money Multiplier ( mm ): (carry out to four decimals) Mm = (cu + 1)/ (cu + res) = 1.25/ 0.25 + 0.0750 = 3.8461 mm = Money Supply ( M ): m = mm x base = 3.8461 x 625 = 2403.85 M = Bank Deposits ( D ): D = Base / (cu + res) = 625 / (0.25 + .0750) = 1923.07 D = Currency held by the public ( C ): C= M – D = 2403.84 – 1923.07 = 480.77 C = Bank Reserves ( R ): Reserves = Base – C = 625 – 480.77 = 144.23 R = In October, 2008, the Federal Reserve began paying interest on reserves. What did this do to the money multiplier? Why did this happen to the money multiplier? Be sure to use your money multiplier equation when answering this question. 4 3.8461 2403.85 1923.07 480.77 144.23 2

Economics 304 Lesson 07 to 09 3. From your textbook: Just as banking panics led to a decline in the money multiplier during the Great Depression, a worldwide financial panic similarly caused the money multiplier to decline in 2008. Below you will find a graph of the currency-deposit ratio ( cu ) and the reserve-deposit ratio ( dep ) from the Great Depression. How were the changes in the currency-deposit ratio ( cu ) different during the Great Recession than depicted above during the Great Depression? Explain why this was the case. How were the changes in the reserve-deposit ratio ( res ) different during the Great Recession than depicted above during the Great Depression? Explain why this was the case. When the fed started paying interest on reserves the money multiplier fell sharply. This was because the reserve- deposit ratio increased which kept a lot of money from being “multiplier fell sharply. This was because the reserve- deposit ratio increased which kept a lot of money from being “multiplied” through the economy as deposits. Algebraically we can see this because the reserve-deposit ratio is in the denominator of the money multiplier equation. Mm = [(C/D) + 1] / [C/D +RR/D + ER/D] = [cu + 1] / [cu + res] During the Great Recession we saw the currency-deposit ratio decrease slightly instead of increase. This was a result of FDIC insurance which insured deposits, Therefore, people did not have a reason to pull money out of deposits. During the Great Recession we saw the reserve-deposit ratio increase significantly more than it did during the Great Depression. The main cause of this was the Federal Reserve began paying interest on reserves. Therefore, banks held a lot of reserves causing the reserve to deposit ratio to skyrocket. 3

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