Banks, the Federal Reserve, and the Money Supply

The money supply is determined by the amount of currency and bank deposits held by the public, as well as the amount of reserves held by banks. Changes in the behavior of banks or their depositors affect the level of the money supply.

Exploration: How does depositor, bank, and Federal Reserve behavior affect the money supply?

The applet above illustrates the relationship between the amount of currency held by the public (C), the amount of reserves in the banking system (R), and the desired reserve-deposit ratio (R/D). The first row of the interactive table below (Initial) gives the level of currency held by the public, bank reserves, the reserve-to-deposit ratio, and the money supply in December, 1929. You can change the values of any of these variables to analyze alternative scenarios. Click the Reset button to restore the original values.

1. Maintain the 1929 value (.075) for the reserve-to-deposit ratio, but increase the amount of currency held by the public by $1 billion and reduce bank reserves by $1 billion. This might be caused, for example, by a banking panic. What happens to the money supply after the increase in currency held by the public? Why has the value of the money supply changed by more than $1 billion?
   
   
2. Restore the original values in the applet by clicking on the Reset button. Now, increase the level of currency held by the public to $4.85 billion, increase the level of bank reserves to $3.45 billion and increase the reserve-to-deposit ratio to .133 (these were the levels occurring in December, 1933). Why would reserves and the desired reserve-to-deposit ratio likely increase during a banking panic? What happens to the money supply after the increase in reserves and the increase in the desired reserve-to-deposit ratio? Why?
   
   
3. Restore the original values in the applet by clicking on the Reset button. Assume that due to a banking panic, consumers withdraw $1 billion in deposits (and reserves) from banks. If the Federal Reserve wants to keep the money supply at its initial level ($45.85 billion), what can it do to offset the withdrawal of deposits by consumers/savers? In particular, determine what adjustments the Federal Reserve must make to the level of bank reserves in the economy to meet its objective. What type of open market operations must the Federal Reserve carry out to meet its objective?
   
   
4. Restore the original values in the applet by clicking on the Reset button. What happens to the money supply if the Federal Reserve reduces the required reserve-deposit ratio to 0.05?
   
   
5. Restore the original values in the applet by clicking on the Reset button. What happens to the money supply if banks decided to hold a larger quantity of reserves against their deposits? What could the Federal Reserve do to offset this change in behavior and keep the money supply at its current level?
   
   
6. Restore the original values in the applet by clicking on the Reset button. If the Federal Reserve increases reserves in the banking system by $100 million, what will be the effect on the money supply, given a desired reserves-to-deposit ratio of .20 and an initial level of reserves of $6 billion? Why is the effect on the money supply greater than $100 million?
   
   

View Answers