Question 1

What components make up the money supply in the money multiplier model?

Accepted Answer

The money supply, denoted as M, consists of two components: currency (C) held by the public on hand and deposits (D) held by the public in banks. Together, these represent all money circulating in the economy and available for transactions. The formula is M equals C plus D.

Question 2

How does the monetary base differ from the money supply?

Accepted Answer

The monetary base (B) comprises currency held by the public and reserves (R) held by banks, expressed as B equals C plus R. The money supply includes deposits instead of reserves. This distinction is crucial because banks create money through fractional reserve banking, making the money supply larger than the monetary base.

Question 3

What does the currency-deposit ratio measure?

Accepted Answer

The currency-deposit ratio (cr) measures the proportion of currency the public prefers to hold relative to bank deposits. It is calculated as the quotient of currency divided by deposits. A higher ratio indicates the public holds more cash on hand compared to deposits, affecting how much money the banking system can create.

Question 4

What is the reserve-deposit ratio and why does it matter?

Accepted Answer

The reserve-deposit ratio (rr) represents the proportion of reserves banks maintain relative to deposits, calculated as reserves divided by deposits. It matters because banks that hold higher reserves create less money through lending, while lower reserves allow greater money creation. This ratio directly influences the money multiplier.

Question 5

How is the money multiplier calculated?

Accepted Answer

The money multiplier equals the sum of the currency-deposit ratio and one, divided by the sum of the currency-deposit ratio and the reserve-deposit ratio. This formula shows how much money supply can be generated from each dollar of the monetary base, demonstrating the amplification effect of banking system operations.

Question 6

What is the relationship between the monetary base and money supply?

Accepted Answer

The money supply is directly related to the monetary base through the money multiplier. By multiplying the monetary base by the money multiplier, you obtain the total money supply. This relationship demonstrates how the federal reserve and money supply work together, with the multiplier capturing the effects of public preferences and banking behavior.

Question 7

How do the currency-deposit and reserve-deposit ratios affect money creation?

Accepted Answer

Both ratios influence the money multiplier and thus total money creation. When the public holds more currency relative to deposits, the multiplier decreases, reducing money creation. Similarly, when banks hold higher reserves relative to deposits, the multiplier decreases. Together, these ratios determine how effectively the monetary base expands into the broader money supply.

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