Chapter 14 Homework Solutions

1.
“The money multiplier is necessarily greater than 1.” Is this statement true, false, or
uncertain?
The money multiplier is defined as (1+c)/(rr+e+c). Under what condition would this variable be
less
than or equal to 1?
(1+c)/(rr+e+c) ≤ 1
1+c ≤ rr + e + c
1 ≤ rr + e
Only if the sum of the reserve requirement plus the excess reserve ratio is bigger than 1 will the
money multiplier ever be smaller than 1. Given that the reserve requirement is almost always
smaller than
20% and excess reserve ratios are rarely larger than 1%, the money multiplier will
pretty much never be less than 1. It is theoretically possible, but practically implausible.
Note further that as long rr + e < 1, the money multiplier will be larger tha
n 1 regardless of what the
currency ratio is.
2. “If reserve requirements on checkable deposits were set at zero, the amount of
multiple deposit expansion would go on indefinitely.” Is this statement true, false, or
uncertain?
As long as e or c are dif
ferent from zero, then there will not be an infinite expansion deposits. Even
if banks loan out 100% of their incoming deposits, some of these loans will not be reinvested
back
in the banking system because people will hold currency. Furthermore, not eve
ry bank will choose
to empty their vaults, keeping some excess reserves to guard against any sudden increases in
deposit outflows.
3.
During the Great De
pression, the currency ratio rose dramatically. What do you think
happened to the money supply?
Al
arge increase in the currency ratio (brought on by a fear of bank failures) caused the money
multiplier to fall sharply. Since the money supply is defined as the multiplier times the monetary
base, the same number of reserves and currency created less mon
ey during this period. The
money supply fell, even though the central bank did make a attempt to increase the monetary
base.
8.
Why might the procyclical behavior of interest rates lead to procyclical movements in
the money supply?
If interest rates ri
se during an expansion, then the desired excess reserve ratio will fall during an
expansion. The opportunity cost of a dollar held as excess reserves is the interest rate that
could
have been earned had that dollar been lent out. As the interest rate ris
e, so too does the
opportunity cost of excess reserves. So banks cut excess reserves during an expansion which
 causes the money multiplier to rise. Holding constant any action taken by the Fed, this increase
in
the money multiplier will lead to an increa
se in the money supply. The exact opposite thing
happens during a recession where lower interest rates reduce the opportunity cost of excess
reserves. Banks increase e and the money multiplier falls.
9.
The Fed buys $100 million of bonds from the publi
c and also lowers r
r
. What will
happen to the money supply?
The $100 million purchase of bonds will increase the monetary base, leading to an increase in
the
money supply. L
owering the reserve requirement causes the money multiplier to rise, leading to
an increase in the money supply.
10.
The Fed has been discussing the possibility of paying interest on excess reserves. If
this occurred, what would happen to the excess reserve ratio (e)?
This decision would reduce the main cost of holding excess rese
rves, the foregone interest that
could have been earned on loans. This policy would cause the excess reserve ratio to rise and
lead to a decrease in the money multiplier and money supply.
14.
If the economy starts to boom and loan demand picks up, what do you predict will
happen to the money supply?
An increase in loan demand will cause the market interest rate to rise.
Higher interest rates will
cause banks to reduce their excess reserves, l
eading to a decrease in e. A lower excess reserve
ratio suggests a larger money multiplier and an increase in the money supply.

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Econ301_Homework4_Answers

Econ301_Homework4_Answers - Money and Banking Summer 2015...

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Money and Banking Summer 2015 Homework 4 Due Date: Aug 12
Q.1 “The Fed can perfectly control the amount of reserves in the system.” Is this statement true, false, or
uncertain? Explain. A: False. Even though it can control the monetary base fairly precisely through open
market operations, it has much less control over the amount of bank reserves in the system because banks
decide how much to borrow from the fed, while the public decides how much currency it wants to hold
relative to deposits, both of which affect the amount of bank reserves. In addition, float and Treasury
deposits can unexpectedly change the amount of reserves in the banking system, which is essentially out of
the control of the Fed.
Q.2 Describe how each of the following can affect the money supply: (a) the central bank; (b) banks; and
(c) depositors. A: (a) The central bank can affect the money supply through open market operations, which
changes the nonborrowed monetary base. It can also affect the monetary base, and hence money supply
by issuing loans to financial institutions, which increases borrowed reserves. Finally, the central bank can
change reserve requirements, which affects the money multiplier, and hence the money supply for a given
monetary base. (b) Banks can affect the money supply through their holdings of excess reserves; less excess
reserves means more loans, and hence a greater money supply. (c) Depositors can influence the money
supply through their holdings of currency versus deposits. A higher currency-deposit ratio leads to a lower
money multiplier, and hence a lower money supply for a given monetary base.
Q.3 “The money multiplier is necessarily greater than 1.” Is this statement true, false, or uncertain? Explain
your answer. A: False. As the formula in Equation (4) indicates, if rr + e is greater than 1, the money
multiplier can be less than 1. In practice, however, e is so small that rr + e is less than 1 and the money
multiplier is greater than 1.

Q.4 If the Fed buys $1 million of bonds from the First National Bank, but an additional 10% of any deposit
is held as excess reserves, what is the total increase in checkable deposits? (Hint: Use T-accounts to show
what happens at each step of the multiple expansion process.) A: The total increase in checkable deposits is
only $5 million, substantially less than the $10 million that occurs when no excess reserves are held. The
reason is that banks now end up holding 20% of deposits as reserves and only lend out 80%, so that the
increase in deposits found in the T-accounts is $1,000,000 + $800,000 + $640,000 + $512,000 + $409,600
+ . . . = $5 million. The T-accounts below show the effect of the securities purchase:
1) Please answer briefly to the following questions from Chapter 14
a) Question 2 The First National Bank receives an extra $100 of reserves but decides not
to lend out any of these reserves. How much deposit creation takes place for the entire
banking system? None. Since there are no loans created from the new reserves, no
additional deposit creation will occur.
b) ) Question 7 “The Fed can perfectly control the amount of the monetary base, but has
less control over the composition of the monetary base.” Is this statement true, false or
uncertain? False. Even though it can control the monetary base fairly precisely through
open market operations, it has much less control over the amount of bank reserves in
 the system because banks decide how much to borrow from the fed, while the public
decides how much currency it wants to hold relative to deposits, both of which affect
the amount of bank reserves. In addition, float and Treasury deposits can unexpectedly
change the amount of reserves in the banking system, which is essentially out of the
control of the Fed. c)
c) Question 9 The Fed buys $100 million of bonds from the public and also lowers the
required reserve ratio. What will happen to the monetary supply? Both the Fed’s
purchase of $100 million of bonds (which raises the monetary base) and the lowering of
the required reserve ratio (which increases the amount of multiple expansion and
raises the money multiplier) lead to a rise in the money supply.
d) d) Applied Problem 20 Using T-accounts, show what happens to checkable deposits in
the banking system when the Fed sells $2 million of bonds to the First National Bank.
The Fed sale of bonds to the First National Bank reduces reserves by $2 million. The net
result is that checkable deposits in the banking system decline by $20 million. The initial
effect on the Fed and the banking system is shown below:
Federal Reserve System Securities −$2 millionReserves −$2 million Assets Liabilities _

Answer: a. Money Supply=currency + checkable deposit

= $600B + $900

B =$1500B
currency deposit ratio=currency/checkable deposit =$600B/$900B =66.7%
excess reserve ratio = excess reserves/checkable deposit = $15B/$900B =1.7%
Monetary Base = currency + total reserve = $600B + $15B + $900B*10% = $705B
Money Multiplier = Money Supply/Monetary Base = $1500B/$705B = 2.13
b. This purchase will increase the monetary base by $1400B. hence with a money multiplier as 2.13, this
will increase the money supply by $1400B*2.13=2982.
c. After this transaction,
excess reserves = $15B+$1400B=$1415B
excess reserve ratio=$1415B/$900B=157.22%
money supply=$600B+ $900B=$1500B
monetary base=$600B+$1415B+$900B*10%=$2105B
money multiplier= money supply/monetary base=0.71
d. This is exactly what we have shown in part c.

Suppose that currency in circulation is $600 billion, the amount of checkable deposits is
$900 billion, excess reserves are $15 billion, and required reserves are $25 billion.
a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and
the money multiplier (required reserve ratio is 0.1).
b. Suppose the central bank conducts an unusually large open market purchase of
bonds held by banks of $ 1400 billion due to a sharp contraction in the economy. How
does money supply change?
c. What can cause money supply to change by less than the amount you calculated in b?
11

Answer:
a). Solution:-
Money supply = Currency in circulation + Checkable deposits.
= 600 Billion + 900 Billion
= $ 1500 Billion.
Currency deposit ratio = Currency in circulation / Checkable deposits.
= 600 Billion / 900 Billion
= 0.6667 i.e., 66.67 % (approx)
Excess reserve ratio = Excess reserves / Checkable deposits.
= 15 Billion / 900 Billion
= 0.0167 i.e., 1.67 % (approx)
Required reserve ratio = Required reserves / Checkable deposits.
= 25 Billion / 900 Billion
= 0.0278 i.e., 2.78 % (approx)
Money multiplier = (1 + Currency deposit ratio) / (Required reserve ratio + Excess
reserve ratio + Currency deposit ratio)
= (1 + 0.6667) / (0.0278 + 0.0167 + 0.6667)
= 1.6667 / 0.7112
= 2.34 (approx)
Conclusion:-
Money supply $ 1500 Billion.
Currency deposit ratio 0.6667 i.e., 66.67 % (approx)
Required reserve ratio 0.0278 i.e., 2.78 % (approx)
Money Multiplier 2.34 (approx)
Question b). Solution:- Increase in money supply = 1400 Billion * 2.34 = $ 3276
Billion.
Conclusion:- Money supply increases / rises by $ 3276 billion.

1 a. Liability to you (depositor) because you now owe the bank $10,000, asset to the bank
because you owe them principal and interest, neither to Fed Res, bc they play no part
b. Asset to you (depositor), liability to bank bc they owe you $400, neither to Fed Res, bc they
play no part
c. Fed holds an asset to this plus interest, liability to the bank because it owes this much to Fed,
neither to depositors bc they play no part
d. bank that borrows has liability, bank that extended loan holds it as an asset, neither for Fed
e. neither to depositor, liability for bank, neither to Fed

Chapter 13 Homework Solutions

1. If the Fed sells $2 million of bonds to the First National Bank, what happens to
reserves and the monetary base? Use T
-
accounts to explain your answer.
If we assume that First National Bank pays for the bonds out of reserves, then there
will be a $2 million decrease in reserves at First National Bank and a $2 million
increase in securities. At the Fed, there is a decline of $2 million in reserve liabilities
and a $2 million decline in securities (assets).
First Nationl Bank
Assets
Liabilities
Reserves
-
$2 million
Securities
+$2 million
Federal Reserve
Assets
Liabilities
Securities
-
$2 million
Reserves
-
$2 million
The monetary base is defined as currency in circulation plus reserves. The $2
million
drop in
reserves means that the monetary base fell by $2 million.
2. If the Fed sells $2 million of bonds to Irving the Investor, who pays for the bonds
with
a briefcase filled with currency, what happens to reserves and the monetary base?
Use T
-
accounts to ex
plain your answer.
This transaction causes currency in circulation to fall by $2 million. Since the entire
transaction was carried out in cash, there is no change in bank reserves. The
monetary
base still falls by $2 million, though.
Irving the Inves
tor
Assets
Liabilities
Currency
-
$2 million
Securities
+$2 million
Federal Reserve
Assets
Liabilities
Securities
-
$2 million
Currency
-
$2 million
7. Suppose that the Fed buys $1 million of bonds from the First National Bank. If
the
First National Bank and all other banks use the resulting increase in reserves to
purchase
securities only and not make loans, what will happen to checkable deposits?
This is a somewhat tricky question in that you are not told who First National Bank
purchases securities from. The Fed’s purchase causes reserves in the banking
system to
rise by $1 million. First National then uses this $1 million to purchase securities
(presumably from someone other than the Fed!) Suppose they buy the security
from an
individual
. This means that there is now $1 million more currency in circulation.
Suppose that $1 million is deposited in the bank. The bank then places a required
fraction of this $1 million in reserves (based on the reserve requirement) and uses
the
remainder
to purchase a security.
With a 10% reserve requirement, the bank will buy
$900,000 worth of securities. The person who sold these securities will now have
$900,000 to deposit in the bank. They do so and total deposits are now $1 million at
the
first ba
nk and $900,000 at the second bank = $1,900,000. The second bank places 10%
of the $900,000 in reserve and uses the remaining $810,000 to buy securities from
another individual. That individual deposits the proceeds from her sale into her bank
and the pr
ocess continues. Evenutally through the process of multiple deposit creation,
the total value of deposits created will be $1 million * (1/rr) = $1 million * (1/0.1) =
$10
million.
8. If the Fed buys $1 million in bonds from the First National Bank, but
an additional
10% of any deposit is held as excess reserves, what is the total increase in
checkable
deposits?
Assuming that there is a 10% reserve ratio, then holding 10% excess reserves will
lead to
20% of total deposits being held in reserve. The sim
ple money multiplier becomes 1/0.2
= 5. As a result, multiple deposit creation will turn $1 million of reserves into $5
million
of deposits.
12. If the required reserve ratio on checkable deposits increases to 20%, how much
multiple deposit creation wil
l take place when reserves are increased by $100?
Recall that reserves are related to deposits by the following formula:
ΔD = (1/rr)*
ΔR, where rr is the reserve requirement.
ΔD =(1/0.2)*100 = $500
15. If you decide to hold $100 less cash than usual
and therefore deposit $100 in cash in
the bank, what effect will this have on checkable deposits in the banking system if
the
rest of the public keeps its holdings of currency constant?
According to the situation outlined above, there will be a $100 inc
rease in reserves.
Through the process of multiple deposit creation, we will see a $100/rr increase in
deposits. If rr = 10%, then deposits will rise by $1000. If rr was 5%, deposits would
rise
by $2000. If rr was 20%, deposits would only rise by $500
The Fed buys $100 million of bonds from the public and also lowers the required
reserve
ratio. What will happen to the money supply?
When the fed buys more bonds and lowers rr the money supply will INCREASE.
With lower rr banks will be able to loan out more money to the public, increasing Ms.
When the fed buys bonds the money from that purchase will go into circulation,
increasing Ms
"Considering that raising reserve requirements to 100% makes complete control of the
money supply possible, Congress should authorize the Fed to raise reserve
requirements to
this level." Discuss.
IF the rr were to increase to 100% than the Fed would have complete control.
this would make banks unable to make loans to the public because there will be no
excess reserves.
ultimately lowering the Money Supply.
Decrease in Ms will cause the economic growth to seize.

What incentives arise for a central bank to fall into the time-inconsistency trap of
pursuing
overly expansionary monetary policy?
In the Short-Run there is a dual mandate, able to achieve maximum Employment,
causing prices in the Long-Run to rise continuously causing inflation.
"Since financial crises can impart severe damage to the economy, a central bank's
primary
goal should be to ensure stability in financial markets." Is this statement true, false, or
uncertain? Explain.
False:Most central banks in Advanced countries have made it so that price stability is
their main goal, once satisfied will focus on others.
True:if the Policy makers fail and financial crisis is more damaging than high inflation