May 01 2008
The following question was submitted by “blobber008” to the discussion forum at our class wiki:
When I need to find the maximum increase in the total money supply, where the money deposited is $100 and the reserve requirement is 10 percent, do I multiply the total money deposited by the money multiplier, or do I multiply the excess reserves by the multiplier to find the increase, or does it depend on the situation? I thought that I would multiply the initial deposit by the multiplier, thus getting an increase of $1000. My answer key, though, said that increase is $900. When I asked my teacher, she said that you subtract out the original $100 from the $1000 to get the increase in money supply.
The reason I’m confused is that another question asking for an increase resulting from the Fed buying securities from the public doesn’t subtract out the original value. Do you do something different when dealing with money in a bank/checking account and the purchase of securities? Or, do I really subtract out the initial deposit? If so, can you explain why?
This is a good question and one that often comes up among students and even teachers via the AP Economics teacher email group.
The basic difference between an individual depositing $100 and the Fed buying $100 worth of bonds from a commercial bank is that when the individual deposits money, it was already part of the money supply. This is is why the amount of new money created is only $900 when an individual deposits $100 in the bank. We multiply the $100 by the money multiplier (1/required reserve ratio), and then subtract the original deposit, since it was already held by the public, thus part of the money supply.
In the case of the Fed’s purchase of bonds, on the other hand, the $100 of new reserves at the bank are themselves new money, since money held by the fed is not part of the money supply. In this case, we multiply the change in deposits by the multiplier, and the new money created includes the initial change in deposits, which came from the Fed.
Thanks for your submission, hope that helped!
About the author: Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author
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