Homework Exercises – 5
Chapter 10 problems
1. “Unemployment us a bad thing, and the government should make every
effort to eliminate it.” Do you agree or disagree? Explain your answer.
2. Which goals of the Fed frequently conflict?
3. “If the demand for reserves did not fluctuate, the Fed could pursue both a
non-borrowed reserves target and an interest-rate target at the same time.”
Is this statement true, false or uncertain? Explain your answer.
4. Classify each of the following as either an operating target or an intermediate
target, and explain why.
a. The three-month Treasury bill rate.
b. The monetary base
5. Which procedures can the Fed use to control the three-month Treasury bill
rate? Why does control of this interest rate imply that the Fed will lose
control of the money supply?
6. If the Fed has an interest-rate target, why will an increase in the demand for
reserves lead to a rise in the money supply?
7. “Interest rates can be measured more accurately and more quickly than the
money supply. Hence an interest rate is preferred over the money supply as
an intermediate target.” Do you agree or disagree? Explain your answer.
8. Compare the monetary base to M2 on the grounds of controllability and
measurability. Which to do you prefer as an intermediate target? Why?
9. “Discounting is no longer needed because the presence of the FDIC
eliminates the possibility of bank panics.” Is this statement true, false or
uncertain? Explain your answer.
10. The benefits of using Fed discount operations to prevent bank panics are
straightforward. What are the costs?
11. What are the benefits of using a nominal anchor for the conduct of monetary
12. Give an example of the time-inconsistency problem that you experience in
your everyday life?
13. What incentives arise for a central bank to fall into the time-inconsistency
trap of pursuing overly expansionary monetary policy?
14. What are the advantages of monetary targeting as a strategy for the conduct
of monetary policy?
15. What is the big if necessary for the success of monetary targeting? Does the
experience with monetary targeting suggest that the big if is a problem?
16. What methods have inflation-targeting central banks used to increase
communication with the public and increase the transparency of monetary
17. Why might inflation targeting increase support for the independence of the
central bank to conduct monetary policy?
18. “Because the public can see whether a central bank hits its monetary targets
almost immediately, whereas it takes time before the public can see whether
an inflation target is achieved, monetary targeting makes central banks more
accountable than inflation targeting does.” Is this statement true, false or
uncertain? Explain your answer.
19. “Because inflation targeting focuses on achieving the inflation target, it will
lead to excessive output fluctuations.” Is this statement true, false or
uncertain? Explain your answer.
20. “A central bank with a dual mandate will achieve lower unemployment than
a central bank with a hierarchical mandate in which price stability takes
precedence.” Is this statement true, false or uncertain?
Chapter 10 – Quantitative Problems
1. Consider a bank policy to maintain 12% of deposits as reserves. The bank
currently has $10m in deposits and $400,000 in excess reserves. What is the
required reserve on a new deposit of $50,000?
2. Estimates of unemployment for the upcoming year have been developed as
follows. What is the expected unemployment rate? What is the standard
Economy Probability Unemployment Rate (%)
Bust .15 20
Average .5 10
Good .2 5
Boom .15 1
3. The Federal Reserve wants to increase the supply of reserves, so it purchases
1m USD worth of bonds from the public. Show the effect of this open market
operation using T-accounts.
4. Use T-accounts to show the effect of the Federal Reserve being paid back a
$500K discount loan from a bank.
5. The short-term nominal interest rate is 5%, with an expected inflation of 2%.
Economists forecast that next year’s nominal rate will increase by 100 basis
points, but inflation will fall to 1.5%. What is the expected change in real
For problems 6-8 recall from introductory macroeconomics that the money
multiplier = 1/(required reserve ratio).
6. If the required reserve ratio is 10%, how much a new $10,000 deposit can a
bank lend? What is the potential impact on the money supply?
7. A bank currently holds $150,000 in excess reserves. If the current reserve
requirement is 12.5%, how much could the money supply change? How
could this happen?
8. The trading desk at the Federal Reserve sold $100,000,000 in T-bills to the
public. If the current reserve requirement is 8.0%, how much could the
money supply change?
Chapter 10 – Additional Problems
1. Define Monetary Base, M1 and M2.
2. Assume Fred has $500 in cash and that this is the entire monetary base.
Assume that the reserve requirement for banks is 5% and that reserves are
taken on checking accounts but not money market accounts.
a. What is the current level for M1 and M2?
b. If Fred deposits the $500 into his checking account what happens to
M1 and M2? What are the required reserves? How much of the cash
can the bank leave in its own vault?
c. The bank where Fred has a checking account would like to extend a
loan to another customer, Sue. How large a loan can the bank extend?
After the loan what happens to the Monetary Base, M1 and M2? If the
bank deposits the proceeds of the loan into Sue’s checking account
what are the required reserves of the bank?
d. If both Fred and Sue want to withdraw their money at the same time
this would cause a run on the bank. What options does the bank
3. If excess reserves have increased by 100,000 dollars and the required
reserve ratio is 5% then what is the most that M1 can increase?
4. What is the money multiplier? The following graph shows the Monetary
Base, M1 and M2. Given a reason that might explain why M1 and the
Monetary Base lines crossed in 2008.
Jan-00 Nov-01 Sep-03 Jul-05 May-07 Mar-09 Jan-11
Source: Federal Reserve Bank of St. Louis/Board of Governors of the Federal Reserve
System/Board of Governors of the Federal Reserve System/FRED
5. Using T-Accounts show the effect of the Fed reserve buying $1,000 of T-bills
from the Fred and Fred depositing the proceeds into his checking account at
Bank A. What effect will this have on reserves – both required and excess
(assume a reserve ratio of 10%)? What effect will this have on the Monetary
Base, M1 and M2?
6. In the previous problem if Bank A already had excess reserves at the Fed
would Bank A expect to be able to lend any additional excess reserves to
Bank B at a higher or lower rate than the rate seen before the Fed’s open