Tackle the Test: Free-Response Questions

1. Question

   How will each of the following affect the money supply through the money multiplier process? Explain.

   
   

   
   

   1. People hold more cash.

      
      
   
   

   2. Banks hold more excess reserves.

      
      
   
   

   3. The Fed increases the required reserve ratio.

      
      
   
   

   Rubric for FRQ 1 (6 points)

   1 point: It will decrease.

   1 point: Money held as cash does not support multiple dollars in the money supply.

   1 point: It will decrease.

   1 point: Excess reserves are not loaned out and therefore do not expand the money supply.

   1 point: It will decrease.

   1 point: Banks will have to hold more as reserves and therefore loan out less.

2. Question

   Suppose the required reserve ratio is 5%.

   
   

   
   

   1. If a bank has deposits of $100,000 and holds $10,000 as reserves, how much are its excess reserves? Explain.

      
      
   
   

   2. If a bank holds no excess reserves and it receives a new deposit of $1,000, how much of that $1,000 can the bank lend out and how much is the bank required to add to its reserves? Explain.

      
      
   
   

   3. By how much can an increase in excess reserves of $2,000 change the money supply in a checkable-deposits-only system? Explain. (4 points)

      
      
   
   

   Rubric for FRQ 2 (4 points)

   1 point: The bank must hold $5,000 as required reserves (5% of $100,000). It is holding $10,000, so $5,000 must be excess reserves.

   1 point: The bank must hold an additional $50 as reserves because that is the reserve requirement multiplied by the deposit: 5% of $1,000. The bank can lend out $950.

   1 point: $40,000

   1 point: The money multiplier is 1/0.05 = 20. An increase of $2,000 in excess reserves can increase the money supply by $2,000 × 20 = $40,000.