economics money banking

PRACTICE SET FOR MONEY SUPPLY PROCESS

1. Classify each of these transactions as an asset, a liability, or neither for each of the “players” in the

money supply process—the federal reserve, banks, and

depositors.

a. You get a $10,000 loan from the bank to buy an automobile.

Public:

Assets Liabilities

Banks:

Assets Liabilities

b. You deposit $400 into your checking account at the local bank.

Public:

Assets Liabilities

Banks:

Assets Liabilities

Fed:

Assets Liabilities

c. The Fed provides an emergency loan to a bank for $1,000,000.

Banks:

Assets Liabilities

Fed:

Assets Liabilities

d. A bank borrows $500,000 in overnight loans from another bank.

2. Suppose 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 to make loans, what will happen

to checkable deposits?

Checkable deposits will -------------------------------------

3. If a bank depositor withdraws $1,000 of currency from an account, what happens to reserves, checkable

deposits, and the monetary base?

Reserves will -------------------------------

Checkable deposits will ------------------------------,

The monetary base will -------------------------------------

4. If a bank sells $10 million of bonds to the Fed to pay back $10 million on the loan it owes, what is the effect on the

level of checkable deposits?

checkable deposits -------------------------------------

5. If you decide to hold $100 less cash than usual and therefore deposit $100 more 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?

The deposit of $100 in the bank ---------------------

its reserves by ----------------.

6. “The Fed can perfectly control the amount of borrowed reserves in the banking system” Is this statement true,

false, or uncertain?

7. If credit risk in the banking system increases, all else equal what effect, if at all, will this have on the money

multiplier?

8. What effect might a financial panic have on the money multiplier and the money supply? Why?

9. In October 2008, the Federal Reserve began paying interest on the amount of excess reserves held by banks.

How, if at all, might this affect the multiplier process and

the money supply?

APPLIED PROBLEMS

Unless otherwise noted, the following assumptions are

made in all of the applied problems:

the required reserve ratio on checkable deposits is 10%,

banks do not hold any excess reserves, and

the public’s holdings of currency do not change.

10. 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.

(the required reserve ratio on checkable deposits is 10%,

banks do not hold any excess reserves, and the public’s

holdings of currency do not change.)

Reserves and the monetary base -------------------------

First National Bank

Assets Liabilities

Reserves ---------

---

Securities ---------

----

Federal Reserve System

Assets Liabilities

Securities --------- Reserves ---------

11. 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 explain your answer.

(the required reserve ratio on checkable deposits is 10%,

banks do not hold any excess reserves, and the public’s

holdings of currency do not change.)

Reserves -------------------------,

the monetary base ----------------------------------------

Irving the Investor

Assets Liabilities

Currency

Securities

Federal Reserve System

Assets Liabilities

Securities

Currency

12. If the Fed lends five banks a total of $100 million but depositors withdraw $50 million and hold it as currency,

what happens to reserves and the monetary base? Use

T-accounts to explain your answer.

(the required reserve ratio on checkable deposits is 10%,

banks do not hold any excess reserves, and the public’s

holdings of currency do not change.)

The initial effect of the loans on the banking system,

Federal Reserve, and public are shown below.

Banking System (all five banks)

Assets Liabilities

Reserves Loans (borrowings from the

Fed)

Federal Reserve System

Assets Liabilities

Loans

(borrowings from the Fed)

Reserves

Public

Assets Liabilities

After the public withdraws $50 million in deposits to

hold as currency, the T-accounts look like this:

Banking System (all five banks)

Assets Liabilities

Reserves Loans

(borrowings from the Fed)

Checkable Deposits

Federal Reserve System

Assets Liabilities

Loans

(borrowings from the Fed)

Reserves

Currency

Public

Assets Liabilities

Checkable Deposits

Currency

13. Using T-accounts, show what happens to checkable deposits in the banking system when the Fed lends $1

million to the First National Bank.

The initial effect of the loans provided by the Fed is

shown in the T-accounts below:

Federal Reserve System

Assets Liabilities

Loans -------------million

(borrowings from the Fed)

Reserves ----million

Banking System

Assets Liabilities

Reserves------million Loans (borrowings from the Fed)

------- million

After the banks receive the reserves, those excess

reserves are ------------;

The final effect of the ----------------------------- is shown

in the T-accounts below:

Federal Reserve System

Assets Liabilities

Loans (borrowings from the Fed)

----- million

Reserves -----

million

Banking System

Assets Liabilities

Reserves ------- Loans (borrowings from the Fed)----

Loans -------

CheckableDeposits -------------

14. If the Fed sells $1 million of bonds and banks reduce their borrowings from the Fed by $1 million, predict

what will happen to the money supply.

The Fed’s sale of $1 million of bonds -------------- the

monetary base by ----- million, and the reduction of

borrowing from the Federal Reserve --------- the

monetary base by

-------------------- million.

The ----------------------------- in the monetary base

leads -------- in the money supply.

15. Suppose that currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, and

excess reserves are $15 billion.

a. Calculate the money supply, the currency deposit ratio, the excess reserve ratio, and the money

multiplier.

The money supply is given as M = C + D

M = --------------------------------------billion;

c = C / D = ---------------------;

e = ER / D = --------------------;

m = (1 + c) / (rr + e + c) = --------------------------------

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. Assuming the ratios you

calculated in part (a) remain the same, predict the

effect on the money supply.

The monetary base will -------------------------------

billion;

given the money multiplier calculated in part (a),

this implies

the money supply should -------------------- to ---------

------------------------------------ billion

c.Suppose the central bank conducts the same open market

purchase as in part (b), except that banks choose to hold

all of these proceeds as excess reserves rather than loan

them out, due to fear of a financial crisis. Assuming that

currency and deposits remain the same, what happens

to the amount of excess reserves, the excess reserve

ratio, the money supply, and the money multiplier?

ER = ------------ billion;

e = ------------------------;

m = -----------------------

The money supply is -------------------------- billion,

since -------------------------------------

d.During the financial crisis in 2008, the Federal Reserve

began injecting the banking system with massive

amounts of liquidity, and at the same time, very little

lending occurred. As a result, the M1 money multiplier

was below 1 for most of the time from October 2008

through 2011. How does this scenario relate to your

answer to part (c)?

The results from part (c) demonstrate that if large

amounts of reserves enter the banking system but

are held as excess reserves, it is possible for the

money multiplier to -------------------------------.