Slides By John Dawson and Kevin Brady Begin Money Multiplier Interactive Examples To navigate, please click the appropriate green buttons. (Do not use the arrows on your keyboard) Material from this presentation can be found in: Chapter 22

Answer Money Multiplier Banks are required, by law, to hold a minimum amount of their customers’ deposits in reserves. These reserves are known as reserve requirements. Banks can voluntarily hold more reserves than are required by law. Any reserves held by a bank that exceed its required reserves are known as excess reserves. Required reserves and excess reserves together make up total reserves. QUESTION 1: Suppose banks are required by law to hold 5% of their deposits in reserves and that banks hold only the reserves required by law. Assume total deposits are $100 million. A.Calculate exact values for the reserve requirement, excess reserves, and total reserves. B.Calculate the exact value for the money multiplier. C.Suppose the Federal Reserve adds an additional $1 million in reserves through open market operations. Calculate the amount by which the money supply will change. Interactive Examples

Next Question Money Multiplier ANSWER TO QUESTION 1: A.If banks hold only those reserves required by law, the reserve requirement = $100 million × 0.05 = $5 million, excess reserves = 0, and total reserves = $5 million. Note that total reserves = reserve requirement + excess reserves. B.The money multiplier = 1/(reserve requirement) = 1/0.05 = 20. C.Change in money supply = money multiplier × change in reserves = 20 × $1 million = $20 million. Interactive Examples

Answer Money Multiplier QUESTION 2: During the banking crisis of associated with the Great Depression, banks’ holdings of excess reserves increased sharply while the Federal Reserve took little action to increase reserves in the banking system. What effect would you expect these developments to have on the money multiplier and money supply in the economy? Interactive Examples

Next Question Money Multiplier ANSWER TO QUESTION 2: A sharp increase in excess reserves implies a sharp decrease in the money multiplier. With little or no offsetting change in reserves by the Fed, a sharp decline in the money supply would follow. Indeed, this is precisely what happened during the Great Depression, with the money supply falling by about one-third during this period! Interactive Examples

Answer Money Multiplier QUESTION 3: During the financial crisis of late 2007 and 2008, banks’ holdings of excess reserves once again increased sharply as they experienced large loan losses. Explain how the Federal Reserve—this time around—responded to this situation in a way that might have prevented many of the banking and money supply problems experienced at the time of the Great Depression. Interactive Examples

The End Money Multiplier ANSWER TO QUESTION 3: Once again, increased excess reserves in the banking system imply a sharp decline in the money multiplier. But the Fed did—this time around—respond by sharply increasing reserves in the banking system (through open market operations) to prevent the money supply from falling sharply. This action likely prevented a sharp decline in the money supply and many of the problems that followed in the banking system and economy as a whole during the Great Depression. Interactive Examples