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Money and the money supply multiplier
Consider an economy with a banking sector. Money demand is given by Md = $Y(0.25- 2i) where $Y is $4trn. Suppose that people desire to hold 20% (c=0.2) of their money in currency and 80% in deposits. Also, suppose that banks hold 10% of all deposits as reserves (θ=0.1). Given that the central bank desires to keep the interest rate at 1% (i=0.01):
a) What will be overall money supply (M) in equilibrium?
b) What will be the supply of central bank money (H)? If the central bank decides to reduce the interest to 0%:
c) What must happen to overall money (M)? Explain why.
d) What must happen to central bank money (H)? Explain why.
e) Calculate the money multiplier. Explain its meaning. During the Great Depression in the 1930s, bank runs led to people taking their money out of banks, preferring to keep it in currency.
f) How did this shift from deposits to cash affect the size of the money multiplier?
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