# Econ161SQ7_Monetary System_ - California State University_ Northridge money loans

Document Sample

```					Economics 161
Fall 2003
Study Questions on the Monetary System
1. What are the functions of money? What is M1?…M2? What is meant by “liquidity”?
2. What is the Federal Reserve System? What are primary functions of the Fed? Who controls the Fed?
3. What are reserves? What is the required reserve ratio?
4. a. Suppose the Fed purchases \$2,000 worth of bonds from the public. It pays for these bonds with
currency. The public than deposits this currency in its account at Bank A. immediately after this
transaction, Bank A’s T-account will look like (fill in table below):
Bank A

Reserves                    Demand Deposits

Loans

4b. Does Bank A have any excess reserves? Assume that the required reserve ratio (R) is 20%. If so, what
does this allow Bank A to do? For your answer, fill in the table below:

Bank A

Reserves                    Demand Deposits

Loans

Does Bank A still have excess reserves after the above transactions?

4c. Suppose the Firm L (or whoever it was that received the loan in part 4b) uses the proceeds of the loan
to buy goods from Firm M. Firm M then deposits this currency in its deposit at Bank B.
Immediately after this transaction, Bank B’s T-account looks like:
Bank B

Reserves                  Demand Deposits

Loans

4d. Does Bank B have any excess reserves? If so, what does this allow Bank B to do? For your answer, fill
in the table below:
Bank B

Reserves                  Demand Deposits

Loans

Does Bank B still have excess reserves after the above transactions?

4e. Suppose the Firm N (or whoever it was that received the loan in part 4d) uses the proceeds of the loan
to buy goods from Firm O. Firm O then deposits this currency in its deposit at Bank C.
Immediately after this transaction, Bank C’s T-account looks like:
Bank C

Reserves                  Demand Deposits

Loans
4f. Does Bank C have any excess reserves? If so, what does this allow Bank C to do? For your answer, fill
in the table below:
Bank C

Reserves                  Demand Deposits

Loans

Does Bank C still have excess reserves after the above transactions?
4g. What is the ultimate increase in the money supply for the entire banking system?
5. What are the three tools used by the Fed for controlling the money supply? Define terms when relevant.
Explain how each tool affects the money supply.
6. Find the money multiplier when R = 5%. What happens to the money multiplier when R rises to 10%?
7. Suppose the required reserve ratio is 5%. Reserves are \$49 billion. If the Fed desires that the money
supply be \$1 trillion, by how much would it have to change reserves by to achieve this goal?
8. An open-market purchase of \$10 billion will lead to what change in the money supply? Assume that
R=10%.
9. Multiple choice question. If the Fed desires to decrease the money supply it should:
a. engage in an open-market purchase of bonds.
b. lower the required reserve ratio.
c. lower the discount rate.
d. any of the above.
e. none of the above.
10. What is the FOMC?
11. What problems does the Fed encounter in its control of the money supply? How does the Fed reduce
these problems?
12. Multiple choice question. Suppose the Fed expects the non-bank public to suddenly withdraw large
amounts of currency from banks. If the Fed desires to keep the money supply constant, it should:
a. engage in an open-market sale of bonds.
b. raise the discount rate.
c. raise the required reserve ratio.
d. engage in an open-market purchase of bonds.
e. none of the above.
1. Functions of money: a. Medium of exchange-the thing that is commonly used to make purchases or pay
debts. b. Unit of account- the unit in which prices are expressed. c. Store of value (or store of wealth)-
allows us to store our purchasing power before we spend.
M1 = Currency in the hands of the non-bank public + Demand deposits (checking accounts).
M2 = M1+ savings deposits + small time deposits + money market mutual funds + other.
Liquidity: the ease and quickness at which one asset can be traded for another asset.
2. Federal Reserve System (the Fed) is the central bank of the U.S. The primary functions of the Fed are to
regulate the banking system and control the money supply. Control of the Fed resides with the Board of
Governors. The Board of Governors consists of seven members appointed by the President and approved
by the Senate. The Chairman of the Board of Governors is Alan Greenspan.
3. Reserves = vault cash + deposits banks have at the Fed. The Fed requires that banks hold a certain
minimum amount of reserves. The required reserve ratio represents the minimum amount of reserves that
banks are required to hold stated as a percentage of demand deposits. For example, if the required reserve
ratio is 10% and a bank has demand deposits of \$200 million, then the bank will be required to hold
at least 0.10*200 million = \$20 million of reserves. (Note: the fact that the bank is only required to hold a
reserves which are a fraction of its deposits gives us the name “Fractional-Reserve System”).
After 4a:
Bank A

Reserves     \$2000                Demand Deposits \$2000

Loans

4b. Yes. Actual reserves = \$2000
Required reserves (R)(Deposits)=0.20*2000= \$400.
Excess reserves = 2000-400 = \$1600.
This allows the bank to expand loans by \$1600. So suppose we assume that Bank A makes a loan of
\$1600 to Firm L. For simplicity, we assume the loan is made in the form of cash. Immediately after these
transactions we have
Bank A

Reserves     \$400           Demand Deposits \$2000

Loans        \$1600

Bank A no longer has excess reserves after this set of transactions:
Actual reserves = \$400
Required reserves (R)(Deposits)=0.20*2000= \$400.
Excess reserves = 400-400 = 0.
Bank A cannot make any more loans since excess reserves are zero.

4c.                          Bank B

Reserves     \$1600          Demand Deposits \$1600

Loans

4d. Yes. Actual reserves = \$1600
Required reserves (R)(Deposits)=0.20*1600= \$320.
Excess reserves = 1600-320 = \$1280.
This allows the bank to expand loans by \$1280. So suppose we assume that Bank B makes a loan of
\$1280 to Firm N. For simplicity, we assume the loan is made in the form of cash. Immediately after these
transactions we have
Bank B

Reserves    \$320           Demand Deposits \$1600

Loans       \$1280

Bank B no longer has excess reserves after this set of transactions:
Actual reserves = \$320
Required reserves (R)(Deposits)=0.20*1600= \$320.
Excess reserves = 320-320 = 0.
Bank B cannot make any more loans since excess reserves are zero.
4e.                         Bank C

Reserves    \$1280          Demand Deposits \$1280

Loans

4f. Yes. Actual reserves = \$1280
Required reserves (R)(Deposits)=0.20*1280= \$256.
Excess reserves = 1280-256 = \$1024.
This allows the bank to expand loans by \$1024. So suppose we assume that Bank C makes a loan of
\$1024 to Firm P. For simplicity, we assume the loan is made in the form of cash. Immediately after these
transactions we have
Bank C

Reserves    \$256           Demand Deposits \$1280

Loans       \$1024

Bank C no longer has excess reserves after this set of transactions:
Actual reserves = \$256
Required reserves (R)(Deposits)=0.20*1280= \$256.
Excess reserves = 256-256= 0.
Bank C cannot make any more loans since excess reserves are zero.
4g. Deposits (or money supply) = (1/R)(Reserves in banking system)=(1/0.20)(\$2000) = \$10,000.
5. i. Open-Market Operations: the purchase and sale of US government bonds by the Fed.
An open-market purchase of bonds by the Fed leads to the injection of reserves into the banking system.
For example, suppose the Fed directly buys bonds from Bank A then:

Bonds
Fed              Bank A

Reserves
As can be seen by the equation --Deposits (or money supply) = (1/R)(Reserves in banking system) --- as
reserves increase the money supply rises.
An open-market sale of bonds by the Fed leads to the reduction of reserves in the banking system.
For example, suppose the Fed directly sells bonds to Bank A then:

Reserves
Fed            Bank A

Bonds
As can be seen by the equation ---Deposits (or money supply) = (1/R)(Reserves) --- as reserves decrease
the money supply decreases.
ii.Changes in the required reserve ratio. The money multiplier is defined as (1/R). As ratio indicates, as R
rises the money multiplier falls, and as R falls the money multiplier rises. Now look at the following
equation:      Deposits (or money supply) = (1/R)(Reserves). As can be seen from this equation, if R was
drop, then (1/R) would rise and hence the money supply would rise. If R was rise, then (1/R) would fall and
therefore the money supply would fall.
iii. Changes in the discount rate. The discount rate is the interest rate on loans that the Fed makes to banks.
If the Fed cuts the discount rate, then banks find more desirable to borrow from the Fed. Since the Fed
lends them reserves, this increases the amount of reserves in the banking system. As can be seen by
Deposits (or money supply) = (1/R)(Reserves), as the reserves rise, the money supply rises.
On the other hand, the higher discount rate discourages banks from borrowing reserves from the Fed, and
so there is a drop in the amount of reserves in the banking system. The drop in reserves leads to a drop in
the money supply.
6. Money multiplier = (1/R) = 1/0.05 = 20. If R =10%, the (1/R)=1/0.10=10. So the money multiplier falls
when R rises.
7. First, find the current money supply. Deposits = (1/R)(Reserves)=(1/0.05)(49 Billion)= \$980 Billion.
Second, find the Fed’s desired change in the money supply. \$1,000 billion- \$980 billion =\$20 billion.
Third, use the following equation to find desired change in reserves
Change in Deposits = (1/R)(Change in Reserves)
+\$20 billion = (20)(Change in Reserves)
\$1 billion = change in reserves.
8. First, note that an open-market purchase increases reserves by the amount of the purchase. Therefore,
a purchase of \$10 billion will increase reserves in the banking system by \$10 billion.
Second, we use the following equation:
Change in Deposits = (1/R)(Change in Reserves)= (1/0.1)(+\$10 billion)= +\$100 billion.
10. The FOMC (Federal Open Market Committee) determines open-market operations. The FOMC
consists of the 7 members of the Board of Governors + 5 Presidents of the Fed’s districts banks (one of the
five presidents is always the NY District Bank president).
11. i. The Fed does not control the amount of currency that the non-bank public desires to hold. Thus, if the
public withdraws currency from banks, banks lose reserves and therefore the banking system creates less
money. So the money supply falls without any action on the part of the Fed. The Fed, however, can take
offsetting action if it observes this withdrawal of currency. For example, it can inject new reserves into the
banking system by an open-market purchase of bonds and/or by cutting the discount rate. Or it can reduce
the required reserve ratio.
ii. The Fed cannot control the amount bankers choose to lend. That is, banks may choose to keep excess
reserves. So if the Fed injects reserves into the banking system and if banks do not lend out all of their
excess reserves, the Fed cannot be sure how much the money supply will change by. Again, if the Fed can
correctly anticipate the amount of excess reserves banks desire to hold then it can always take offsetting
actions.