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Chapter 8
Questions
p.38
Think it over
1.
Can a magician create money?
2.
Can a bank create money from deposits?
p.42
Discuss
8.1
Suggest possible reasons for the following.
a. M1 includes only demand deposits, not savings and time deposits with licensed banks.
b. M2 includes only deposits with licensed banks, not deposits with restricted licence
banks and deposit-taking companies.
c. M3 includes only NCDs issued by deposit-taking institutions held by the public, not
those held by deposit-taking institutions.
p.45
Test yourself
8.1
What are the immediate effects of each of the following asset transfers on M1, M2 and M3,
respectively?
a. Ms B withdraws HK$1,000 cash from her savings account.
b. An immigrant converts US$1 million into HK$7.8 million. He then deposits half of it in
his current account and uses half of it to buy NCDs issued by a restricted licence bank.
p.47
Discuss
8.2
Which types of deposits can the initial deposit and deposits created be for the creation of M2
and M3, respectively?
NSS Exploring Economics 6
Questions and Answers to Exercises (Chapter 8)
p.54
Test yourself
8.2
Suppose there is an initial cash deposit of $1,000. If the required reserve ratio is 100%, what
will the maximum increases in deposits, loans, money supply and reserves be, respectively?
Discuss
8.3
Suppose the required reserve ratio is 10% and Louis deposits $500 into a bank. Will the
increases in deposits, loans and money supply attain their maximum possible values when
each of the following happens?
a. Banks decide to hold excess reserves.
b. Demand for loans is insufficient.
c. Cash leakage exists.
p.57
Test yourself
8.3
Refer to Fig. 8.14. Illustrate how Processes A, B, C and D affect the balance sheets of Banks
X and Y, respectively.
pp.64-68
Exercises
Multiple Choice Questions
1.
Which of the following statements about the issue of currency in Hong Kong is correct?
A. Notes are issued by the three note-issuing banks but coins are issued by the Hong Kong
Government.
B. To issue notes, note-issuing banks have to buy Certificates of Indebtedness from the
Exchange Fund.
C. Notes are fully backed by foreign currency but coins are not.
D. All of the above
2.
Which of the following statements about the definitions of money supply in Hong Kong is
correct?
A. M1 is equal to the sum of legal tender held by the public and demand deposits with
licensed banks.
B. M2 is equal to the sum of M1 and deposits with licensed banks.
C. M3 is equal to the sum of M2 and time deposits with restricted licence banks and
deposit-taking companies.
D. All of the above
3*.
Suppose Hong Kongs money supply (in $ billion) in a certain year was:
Total issue of legal tender
12
Demand deposits
10
20
12
15
5.
Which of the following assumptions is necessary for money creation?
A. The initial deposit does not come from deposits of other banks.
B. Banks keep no excess reserves.
C. Banks can lend as much as they like.
D. There is no cash leakage.
6*.
Which of the following may reduce the actual reserve ratio of a banking system?
A. An increase in the required reserve ratio
B. An increase in the demand for bank loans
C. An increase in the amount of cash leakage
D. An increase in the default risk of bank loans
7.
A bank has total deposits of $1,000 million. It has reserves of $180 million but the required
reserve ratio is 20%. Which of the following will help the bank fulfil the reserve
requirement?
A. Customers deposit $20 million in the bank.
B. Customers withdraw $20 million from the bank.
C. The bank borrows $20 million from the inter-bank market.
D. The bank lends $20 million to customers.
8.
The following is the balance sheet of a banking system.
Assets ($)
Reserves
Loans
Liabilities ($)
200
600
Deposits
800
9.
Suppose a person deposits $400 cash in his current account. If both the actual and legal
reserve ratios are 20%, the maximum possible change in
A. M1 is a decrease of $400.
B. M1 is an increase of $1,600.
C. bank loans is an increase of $2,000.
D. reserves is uncertain.
10.
The following is the balance sheet of a banking system.
Assets ($)
Reserves
Loans
Liabilities ($)
400
1,100
Deposits
1,500
If the required reserve ratio is 20%, which of the following statements is correct?
A. The banking system has excess reserves of $200.
B. The banking system can expand its total deposits to $2,500.
C. The maximum amount of loans the banking system can make is $1,600.
D. The money supply can increase by $400.
Short Questions
1.
What are monetary base and money supply M1? What are their differences?
(8 marks)
2.
What are the three definitions of money supply in Hong Kong?
(6 marks)
3*.
Savings deposits can also be used to settle payments by EPS and PPS. Why are savings
deposits NOT included in M1?
(3 marks)
4.
What is the immediate effect on money supply M1 in each of the following situations?
a. A depositor puts $8,000 cash into a current account.
(2 marks)
b. A bank lends $100,000 cash to a borrower.
(2 marks)
c. A borrower repays a bank loan of $5,000,000 by cash.
(2 marks)
d. A depositor withdraws $1,000,000 cash from a time deposit account with a restricted
licence bank.
(2 marks)
5*.
After receiving a cash deposit, a banking system can create deposits, loans and money. Under
what conditions would the increase in money supply be smaller than and equal to the increase
in deposits, respectively?
(6 marks)
6.
Describe the process of credit contraction that results from a cash withdrawal. State the
assumptions behind the calculation of the maximum contraction.
(8 marks)
Structured Questions
1.
Suppose Hong Kongs money supply (in $ billion) on a certain day was:
a.
b.
c.
100
20
Demand deposits
200
600
150
180
120
40
2.
The table below shows the balance sheet of a banking system. The required reserve ratio
is 20%.
Assets ($ billion)
Cash
Loans
a.
b.
Liabilities ($ billion)
40
40
Demand deposits
80
Find the actual banking multiplier and the maximum banking multiplier.
(3 marks)
Without any new deposits or withdrawals, what are the maximum possible changes in
deposits, loans, money supply and reserves? State the assumptions in arriving at your
answers.
(12 marks)
3*. The following table shows the balance sheet of a banking system.
Assets ($ million)
Reserves
Loans
Liabilities ($ million)
500
1,000
Deposits
1,500
Suppose the legal reserve ratio is 20%. The following are independent events.
a. Winnie receives $100 million remittance from her relatives overseas. She deposits the
remittance into the banking system. What are the maximum possible changes in
deposits, loans, money supply and reserves?
(9 marks)
b. If some depositors withdraw $300 million from their deposits, what are the maximum
possible changes in deposits, loans, money supply and reserves?
(9 marks)
Answers
p.38
Think it over
1.
Man cannot create material.
2.
A bank can create money (credit available for use) from deposits. The principle is discussed
in the text, p.45.
p.42
Discuss
8.1
a. With demand deposits, people can settle payments immediately by drawing cheques.
However, for savings and time deposits, people cannot settle payments before
converting them into cash and/or demand deposits. Hence, M1 includes only demand
deposits, not other deposits.
b. This is because deposits with LBs are more liquid than deposits with RLBs and DTCs.
Deposits with LBs include demand deposits, savings deposits and time deposits of any
maturity, but deposits with RLBs and DTCs include time deposits only. In addition, the
maturity of deposits at DTCs cannot be less than three months.
Deposit interest at LBs is also lower and LBs generally have a greater number of
branches than RLBs and DTCs. Hence, it is less costly for people to withdraw money
from LBs than from RLBs and DTCs.
c. Only NCDs held by the public are available to be used (after converting them into
cash). NCDs held by deposit-taking institutions are not available to be used as they are
held to fulfil the liquidity ratio requirement. Thus, only the former is included in M3, not
the latter.
p.45
Test Yourself
8.1
a. M1 = CP + DL = +$1,000 + $0
= +$1,000
M2 = M1 + SL + TL + NCDL
= +$1,000 $1,000 + $0 + $0
= $0
M3 = M2 + TR+D + NCDR+D
= $0 + $0 + $0 = $0
b.
M1 = CP + DL
= $0 + HK$3.9 million
= +HK$3.9 million
M2 = M1 + SL + TL + NCDL
= +HK$3.9 million + $0 + $0 + $0
= +HK$3.9 million
M3 = M2 + TR+D + NCDR+D
= +HK$3.9 million + $0 + HK$3.9 million
= +HK$7.8 million
p.47
Discuss
8.2
M2: all deposits with licensed banks
M3: all deposits with licensed banks, restricted licence banks and deposit-taking companies
10
p.54
Test Yourself
8.2
Maximum increase in deposits
Initial deposit
1
rrr
1
$1,000
100%
Maximum increase in loans
1
Initial loan
rrr
1
$0
$0
100%
Maximum increase in money supply
Change in cash held by the public Maximum increase in demand deposits
$1,000
- $1,000 $1,000 $0
Maximum increase in reserves
Maximum increase in deposits - Maximum increase in loans
$1,000 - $0 $1,000
Discuss
8.3
The increases in deposits, loans and money supply will not attain their maximum possible
values as the conditions for maximum creation are violated.
a. When banks hold excess reserves, they can loan a smaller amount of their deposits.
b. When the demand for loans is insufficient, banks can loan a smaller amount of their
deposits.
c. When cash leakage exists, smaller amounts of bank loans are redeposited into the
banking system for further lending.
11
p.57
Test Yourself 8.3
1,000
Reserves
200
Loans
800
1,000
Liabilities ($)
Deposits
1,000
Deposits
Liabilities ($)
800
Liabilities ($)
Deposits
800
Liabilities ($)
Deposits
800
pp.64-68
Exercises
Multiple Choice Questions
1. B
Option A is incorrect. The $10 note is issued by HKMA, not the three note-issuing
banks.
Option C is incorrect. Both notes and coins are fully backed by US dollars.
2.
A
Option B is incorrect. Demand deposits have already been included in M1.
M2 = M1 + (SL + TL + NCDL).
Option C is incorrect. M3 = M2 + TR+D + NCDR+D.
3.
C
M2 = Legal tender in circulation + Demand deposits + Savings and time deposits with
licensed banks + (NCDs issued by licensed banks NCDs issued by licensed
banks and held by authorised institutions)
= $[4 + 10 + 20 + (12 5)] billion
= $41 billion
12
4.
D
The transfer of assets includes:
TR+D = -$100,000
TL = +$20,000
DL = +$15,000
CP = +$5,000
Hence, M1 = CP + DL = +$5,000 + $15,000 = +$20,000
M2 = M1 + SL + TL + NCDL = +$20,000 + $0 + $20,000 + $0 = +$40,000
M3 = M2 + TR+D + NCDR+D = +$40,000 + (-$100,000) + $0 = -$60,000
5.
A
The others are conditions of maximum creation, instead of conditions of money creation.
6.
B
Option A is incorrect. This will either raise the actual reserve ratio (if it is smaller than
the new required reserve ratio), or leave it unchanged (if it is larger than or equal to the
new required reserve ratio).
Option B is correct. This may increase bank loans and so may reduce the actual reserves
held by the banking system and lower the actual reserve ratio.
Option C is incorrect. This reduces the total amount of deposits created but has little
effect on the actual reserve ratio.
Option D is incorrect. This reduces banks willingness to lend and raises the actual
reserve ratio.
7.
C
Option A is incorrect. After the deposit, the new total deposits = $1,020 million and the
new actual reserves = $200 million. However, the new required reserves = $1,020
million 20% = $204 million, which is larger than the new actual reserves.
Option B is incorrect. After the withdrawal, the new total deposits = $980 million and
the new actual reserves = $160 million. However, the new required reserves = $980
million 20% = $196 million, which is larger than the new actual reserves.
Option C is correct. After borrowing, the total deposits are still $1,000 million but the
new actual reserves are $200 million, which is just equal to the required reserves of $200
million.
Option D is incorrect. After lending, the total deposits are still $1,000 million and the
new actual reserves = $160 million. However, the required reserves are still $200
million, which is larger than the new actual reserves.
13
8.
D
Since the required reserve ratio is not given, we do not know whether options A, B and
C are correct or not. Since the actual reserve ratio = $200/$800 = 25%, the actual
banking multiplier = 1/25% = 4.
9.
B
With a cash deposit of $400, the maximum possible change in deposits
= $400 1/20% = $2,000.
The maximum possible change in loans = ($400 80%) 1/20% = $1,600.
Maximum possible change in money supply (M1)
= CP + Maximum increase in demand deposits = -$400 + $2,000 = $1,600.
Maximum possible change in reserves
= Maximum change in deposits Maximum change in loans = $2,000 $1,600 = $400.
10. C
Option A is incorrect. Excess reserves = Actual reserves Required reserves
= $400 ($1,500 20%) = $100.
Option B is incorrect. Maximum increase in deposits
= Excess reserves (Initial deposit) 1/20% = $100 1/20% = $500.
Maximum amount of total deposits = $1,500 + $500 = $2,000.
Option C is correct. Maximum increase in loans
= Excess reserves (Initial loan) 1/20% = $100 1/20% = $500.
Maximum amount of total loans = $1,100 + $500 = $1,600.
Option D is incorrect. Maximum increase in money supply
= CP + Maximum increase in demand deposits = $0 + $500 = $500.
Short Questions
1.
The monetary base (M0) is the total amount of currency issued in an economy. It consists of
the currency in the hands of the non-bank public (called cash (CP)) and the currency in the
hands of banks (called reserves (R)) (i.e. M0 = CP + R). (2 marks)
The money supply (M1) is the total amount of money (medium of exchange and store of
value) available in an economy. It consists of the currency in the hands of the non-bank
public and demand deposits with licensed banks (DL) (i.e. M1 = CP + DL). (2 marks)
The monetary base includes the reserves of banks which are legal tender but are not available
for use (mostly required reserves) and are not included in the money supply. The money
supply includes demand deposits with banks which are not currency issued and are not
included in the monetary base. (4 marks)
NSS Exploring Economics 6
Questions and Answers to Exercises (Chapter 8)
14
2.
Money supply definition 1 (M1) is equal to the sum of legal tender notes and coins held
by the public and demand deposits with licensed banks. (2 marks)
Money supply definition 2 (M2) is equal to the sum of M1, savings deposits and time
deposits with licensed banks and negotiable certificates of deposit issued by licensed
banks held by the public. (2 marks)
Money supply definition 3 (M3) is equal to the sum of M2, time deposits with restricted
licence banks and deposit-taking companies, and negotiable certificates of deposit issued
by restricted licence banks and deposit-taking companies held by the public. (2 marks)
3.
Due to the high cost of setting up and operating the EPS and PPS system, EPS and PPS have
not been widely adopted as a means of settling payments, e.g., not accepted by stalls in public
markets or transport companies. Thus, savings deposits are not commonly accepted as a
medium of exchange and a means of payment, and are not included in M1 at present.
(3 marks)
4.
a.
b.
c.
d.
5.
M1 = CP + DL. An increase in the money supply would be smaller than an increase in
deposits if there is a simultaneous decrease in legal tender held by the public. This happens
when the initial deposits come from cash held by the public. (3 marks)
On the other hand, an increase in the money supply would be equal to an increase in deposits
if there is no change in legal tender held by the public. This happens when the initial deposits
come from excess reserves held by the banking sector or from cash held by the foreign sector,
e.g., remittances. (3 marks)
15
6.
Let rrr be the required reserve ratio. Suppose Mr A withdraws cash (= C) from his current
account in Bank X and banks keep no excess reserves. For the deposit C, Bank X keeps only
C rrr as required reserves and has to call back loans of C (1 rrr), say from Ms B, to meet
the withdrawal. Assuming no cash injection into the banking system, Ms B has to withdraw
cash [= C (1 rrr)] from Bank Y to repay the loan. Since banks keep no excess reserves, for
the deposit C (1 rrr), Bank Y keeps only C (1 rrr) rrr as required reserves and has to
call back loans of C (1 rrr) (1 rrr), say from Mr C, to meet Ms Bs withdrawal. This
brings further withdrawals and decreases in deposits. The process of money contraction
continues until the banking system is no longer short of reserves. (4 marks)
Maximum decrease in deposits in the banking system
= C + C (1 rrr) + C (1 rrr)2 + C (1 rrr)3 +
= C 1 / [1 (1 rrr)] = C 1/rrr
= Initial withdrawal Maximum banking multiplier (1 mark)
Maximum decrease in loans
= C (1 rrr) + C (1 rrr)2 + C (1 rrr)3 + C (1 rrr)4 +
= [C (1 rrr)] 1 / [1 (1 rrr)] = [C (1 rrr)] 1/rrr
= Initial decrease in loans Maximum banking multiplier (1 mark)
The assumptions behind the calculation are that (a) banks keep no excess reserves; (b) there
is no cash injection into the banking system. (2 marks)
Structured Questions
1.
a. M1 = Legal tender held by the public + Demand deposits
= (Total issue of legal tender Legal tender held by all deposit-taking institutions)
+ Demand deposits
= $(100 20 + 200) billion = $280 billion (2 marks)
M2 = M1 + Savings deposits and time deposits with licensed banks
+ NCDs issued by licensed banks held by the public
= M1 + (Deposits with licensed banks Demand deposits)
+ NCDs issued by licensed banks held by the public
= $(280 + 600 200 + 150) billion = $830 billion (2 marks)
M3 = M2 + Time deposits with restricted licence banks and deposit-taking companies
+ NCDs issued by restricted licence banks and deposit-taking companies held by
the public
= $(830 + 180 + 40) billion = $1,050 billion (2 marks)
16
b.
c.
2.
a.
Given that SL = -$30 billion, NCDR+D = +$10 billion, TL = +$15 billion and
CP = +$5 billion
M1 = CP + DL = +$5 billion + $0 = +$5 billion (2 marks)
M2 = M1 + SL + TL + NCDL = +$5 billion $30 billion + $15 billion + $0
= -$10 billion (2 marks)
M3 = M2 + TR+D + NCDR+D = -$10 billion + $0 + $10 billion = $0 (2 marks)
The following are some possible transactions. For example, people remit money to a
foreign country; people buy foreign products or assets, etc; people buy government
bonds issued by the monetary authority directly.
(Mark the first TWO possible transactions. 1 mark each.)
Actual banking
=
multiplier
1
Actual reserve ratio
1
$40 billion / $80 billion
= 2 (2 marks)
Maximum banking
=
multiplier
=
b.
1
Required reserve ratio
1
20%
5 (1 mark)
Without any new deposits or withdrawals, the banking system can lend its excess
reserves = Actual reserves Required reserves
= $40 billion ($80 billion 20%) = $24 billion. (1 mark)
Without cash leakage, the initial loan is redeposited. (1 mark)
Hence,
Maximum increase in loans = Maximum increase in deposits
= Initial loans or deposits Maximum banking multiplier (2 marks)
= $24 billion 1/20% = $120 billion (1 mark)
Maximum increase in money supply = CP + DL = $0 + $120 billion = $120 billion
(2 marks)
Maximum increase in reserves = Maximum increase in deposits Maximum increase in
loans = $120 billion $120 billion = $0 (2 marks)
The assumptions of maximum creation are no excess reserves, sufficient borrowing and
no cash leakage. (3 marks)
17
3.
a.
b.
With a new deposit of $100 million, the new actual reserves = $600 million, which is
also the final amount of reserves after the credit creation process. (1 mark)
18