ASTRA is the nickname of a famous hacker whose complete identity has never been made public. He is purportedly a Greek mathematician who hacked into Dassault Group’s network systems to steal weapons technology data and then sold it to a few hundred individuals around the world for approximately $350 ?million. He was apprehended in 2008. ?Assume he has served his prison sentence and recently been released. With no intention of becoming a law-abiding citizen and all of his assets having been seized by authorities long ago, he is in desperate need of cash and devises a new hacking plan. This time his target is the Federal Reserve. He manages to hack into their system and diverts $150 ?million into a private anonymous off-shore account outside the US.
Holding all else equal, answer the following questions:
a. ?How will this affect the size of the US money supply? If reserve requirements are set at an average of 6%, ?how large will the change in the size of the money supply be? (4 ?points)
b. ?How might ASTRA’s theft of reserves affect the following in the US: (6 ?points)
interest rates
inflation
unemployment
c. ?The Fed quickly sets out to reverse any effects that this caper may have had on the economy. What action do you expect the Fed will take to combat this unplanned change in the size of the money supply? How will that action actually work to alter the size of the money supply? (3 ?points)
The Correct Answer and Explanation is :
a. Effect on the U.S. Money Supply and the Multiplier Effect
When ASTRA diverted $150 million into an anonymous offshore account, he effectively removed these funds from the U.S. banking system. This action reduced the reserves available to domestic banks, thereby contracting the money supply.
The money supply is influenced by the reserve requirement ratio, which determines the fraction of depositors’ balances that banks must hold in reserve and not lend out. With a reserve requirement of 6%, banks are required to keep 6% of deposits as reserves and can lend out the remaining 94%. This lending process leads to the creation of new money through the money multiplier effect.
The money multiplier (MM) is calculated as the reciprocal of the reserve requirement ratio:
[ MM = \frac{1}{\text{Reserve Requirement Ratio}} = \frac{1}{0.06} \approx 16.67 ]
Therefore, the total potential change in the money supply (( \Delta M )) due to the $150 million reduction in reserves is:
[ \Delta M = \text{Initial Change in Reserves} \times MM = 150\,\text{million} \times 16.67 \approx 2.5\,\text{billion} ]
Thus, the U.S. money supply could decrease by approximately $2.5 billion as a result of this theft.
b. Potential Economic Impacts
- Interest Rates: A reduction in reserves can lead to a decrease in the supply of loanable funds, causing banks to raise interest rates to attract depositors and maintain liquidity. Higher interest rates can dampen borrowing and spending, potentially slowing economic activity.
- Inflation: A contraction in the money supply reduces the amount of money circulating in the economy, which can lead to lower demand for goods and services. This decrease in demand can exert downward pressure on prices, potentially reducing inflation.
- Unemployment: Higher interest rates and reduced economic activity can lead businesses to cut back on investment and hiring. This reduction in business expansion can result in higher unemployment rates as companies adjust to the decreased demand for their products and services.
c. Federal Reserve’s Response
To counteract the unintended reduction in the money supply, the Federal Reserve would likely engage in expansionary monetary policy. This could involve:
- Open Market Operations: The Fed might purchase government securities from the market, injecting liquidity into the banking system. This action increases bank reserves, allowing for more lending and increasing the money supply.
- Lowering Reserve Requirements: By reducing the reserve requirement ratio, the Fed would allow banks to lend a higher percentage of their deposits, effectively increasing the money supply.
These measures would work to restore the money supply to its desired level, mitigating the negative economic impacts of the reserve theft.