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6 Consider a fractional reserve banking system. The central bank supplies the monetary base B by giving an amount of cash to the public, in the form of currency C, and to banks, in the form of reserves R. Banks can open deposit accounts to the public D. The public can make loans from banks, and in turn bank can use the assets created by these loans L, in order to further open deposit accounts D. Banks like opening deposit accounts and loaning to the public, and they do so as much as they can. Total money supply Mis M=C+D. R What is the money supply M as a function of the money base B? Describe your answer. 3 The economy is going through difficult times and the public think that banks will not get their loans back. Thus, the central bank wants to increase the reserve requirement in the banking system. Initially was at 4% but now it will be at 8%. What happens to the money supply M and the money base B in the economy? How? Provide adequate proof. R 8 What can the central bank do to neutralize the effect of the increase in 80 that M is unaffected? Explain its operating mechanism. 9) For the central bank to achieve a given increase in M, will it have to buy more or less bonds if D increases? Explain how your suggestion works. (6 x 4 = 20 marks) gst 2