Question

The government of Eastlandia uses measures of monetary aggregates similar to those used by the United States, and the central bank of Eastlandia imposes a required reserve ratio of \(10 \% .\) Given the following information, answer the questions below. Bank deposits at the central bank \(=\$ 200\) million Currency held by public \(=\$ 150\) million Currency in bank vaults \(=\$ 100\) million Checkable bank deposits \(=\$ 500\) million Traveler's checks \(=\$ 10\) million a. What is \(\mathrm{M} 1 ?\) b. What is the monetary base? c. Are the commercial banks holding excess reserves? d. Can the commercial banks increase checkable bank deposits? If yes, by how much can checkable bank deposits increase?

Short answer

Answer: The M1 money supply in Eastlandia is $660 million, and the monetary base is $450 million. Yes, commercial banks can increase checkable bank deposits by $2,500 million since they have $250 million in excess reserves.

Step-by-step solution

Calculate M1 Money Supply

M1 Money Supply = Currency held by public + Checkable bank deposits + Traveler's checks M1 = \(150 million + \)500 million + \(10 million = \)660 million So, M1 Money Supply is $660 million.

Calculate Monetary Base

Monetary Base = Currency held by public + Currency in bank vaults + Bank deposits at the central bank Monetary Base = \(150 million + \)100 million + \(200 million = \)450 million So, the Monetary base is $450 million.

Determine Excess Reserves

First, we need to calculate the required reserves. Required Reserves = Checkable bank deposits × Required reserve ratio = \(500 million × 10\% = \)50 million Actual Reserves = Currency in bank vaults + Bank deposits at the central bank = \(100 million + \)200 million = $300 million Now, let's find the excess reserves: Excess Reserves = Actual Reserves - Required Reserves = \(300 million - \)50 million = $250 million So, the commercial banks are holding $250 million in excess reserves.

Calculate the Increase in Checkable Bank Deposits

Since commercial banks have excess reserves, they can increase checkable bank deposits by extending loans. To find out how much checkable bank deposits can increase, you can use the money multiplier formula: Money Multiplier = 1 / Required Reserve Ratio = 1 / 10\% = 10 Increase in Checkable Bank Deposits = Excess Reserves × Money Multiplier = \(250 million × 10 = \)2,500 million So, commercial banks can increase checkable bank deposits by $2,500 million.

Key concepts

M1 Money Supply

The M1 money supply is a vital component of monetary aggregates. It includes the most liquid forms of money that can be easily used for transactions. To understand M1, it's important to know that it comprises three main elements:

• Currency held by the public
• Checkable bank deposits
• Traveler's checks

These components together make up what we call the M1 money supply. In our given scenario, it totals up to $660 million. This monetary aggregate gives us a snapshot of the money readily available in an economy for spending. It's important because it helps policymakers and economists examine how much money is in people's hands, which is useful for understanding economic activity and guiding policy decisions.

Monetary Base

The monetary base, also known as the total reserve money, represents the foundation of the money supply in an economy. It consists mainly of the following:

• Currency held by the public
• Currency kept within bank vaults
• Bank deposits at the central bank

In our example, this adds up to $450 million. The monetary base is crucial because it gives insights into the base level of currency circulation and reserve levels in the economy. Why is this number important? It serves as the central bank’s tool for controlling the supply of money through policies. By altering the monetary base, central banks can influence interest rates, inflation, and overall economic growth. Thus, monitoring the monetary base helps understand how many resources are directly available to commercial banks.

Excess Reserves

Excess reserves refer to the bank reserves held over and above the required reserves prescribed by the central bank. Let's break it down: Required reserves are a percentage of the checkable bank deposits that a bank must hold, dictated by the reserve ratio. In our case, it's 10%. For $500 million in deposits, the required reserve is $50 million. The actual reserves, which include both currency in vaults and deposits at the central bank, sum up to $300 million. Thus, the banks have $250 million in excess reserves ($300 million - $50 million). Excess reserves are significant because they represent the potential for banks to lend more, hence multiplying the money supply within the economy. The larger the excess reserves, the greater the capacity for banks to increase lending, which fuels economic activities and can influence growth.

Money Multiplier

The money multiplier effect is an economic concept that explains how an initial deposit can lead to a larger increase in the total money supply within an economy.The formula for the money multiplier is simple: \[ \text{Money Multiplier} = \frac{1}{\text{Required Reserve Ratio}} \]In our scenario, the required reserve ratio is 10%, so the money multiplier is 10. This means each dollar in reserves supports \(10 in new checkable deposits.Given the \)250 million in excess reserves, applying the multiplier indicates that banks have the potential to increase checkable bank deposits by $2,500 million. The money multiplier effect is essential as it highlights the sensitivity of the banking system to changes in reserve policies, influencing the economy's money supply and liquidity.