Answers to Review Questions

1. Answers to Review Questions • 1.Briefly explain why the Fed does not have precise control over the money supply. • The Fed does not have precise control over the money supply because the multiplier linking the monetary base and the money supply is not perfectly stable or predictable, especially in the short run. The money supply is ultimately controlled by the public, the banks, and the Fed. The public decides how much of the monetary base they will deposit in banks and how much they will hold as currency in the hands of the public. Banks decide the quantity of excess reserves they will hold. The Fed determines the monetary base and the required reserve ratio.

2. The Fed does not have precise control over the money supply because the multiplier linking the monetary base and the money supply is not perfectly stable or predictable, especially in the short run. The money supply is ultimately controlled by the public, the banks, and the Fed. The public decides how much of the monetary base they will deposit in banks and how much they will hold as currency in the hands of the public. Banks decide the quantity of excess reserves they will hold. The Fed determines the monetary base and the required reserve ratio.

3. 2.If the public chooses to hold no currency, does the Fed control the money supply? If depository institutions choose to always loan up, does the Fed have precise control? If both of these situations occur, does the Fed have control?

4. If the public chooses to hold no currency, the Fed still has some control but not complete control over the money supply. The money supply would still be affected by the quantity of excess reserves that banks chose to hold. If depository institutions chose to always "loan up", the Fed would not have complete control of the money supply because the public would still decide how much of the monetary base to deposit into banks and how much to hold. If banks always loan up and if the public always chooses to hold no currency, then the Fed would have complete control of the money supply.

5. 3.In what form can a depository institution hold its required and excess reserves? What are the possible uses of currency outside the Fed?

6. Depository institutions can hold its required and excess reserves in the form of vault cash or deposits at the Fed. • Currency outside the Fed can be held in the hands of the public to be used for purchases of goods and services or as vault cash, where it is part of reserves.

7. 4.If a depository institution has excess reserves, how much can it safely lend? • A depository institution can safely lend out 100 percent of excess reserves.

8. 5.What are offsetting open market operations? When would the Fed use an offsetting open market purchase? An offsetting open market sale?

9. Offsetting open market operations are open market purchases or sales to offset changes that arise in the monetary because of other factors such as changes in float or international transactions. The Fed would use an offsetting open market purchase when there is an unexpected decrease in reserves. The Fed would use an offsetting open market sale when there is an unexpected increase in reserves.

10. 6.Explain how open market purchases and sales influence interest rates. To increase the money supply, should the Fed use an open market purchase or sale?

11. Open market purchases and sales influence the interest rate because they (open market operations) affect the supply of reserves. When reserves increase, banks have more excess reserve to lend and that increases the supply of money and credit, which in turn influences the interest rate.

12. To increase the money supply, the Fed should use an open market purchase that increases the supply of reserves. • The Federal Reserve Float is the excess in reserves or money that results from a check being credited to one bank (or other depository institution) before it is debited from another.

13. 7.Comment on John D. Rockefeller’s statement, “I believe that the power to make money is a gift from God.” Do depository institutions really create money? Explain. • When depository institutions make loans, they disburse the proceeds of the loan by creating a checkable deposit in the amount of the loan. Since checkable deposits are money (part of M1), when depository institutions make loans, they do create money. This is not a gift from God, but the result of a fractional reserve system.

14. When depository institutions make loans, they disburse the proceeds of the loan by creating a checkable deposit in the amount of the loan. Since checkable deposits are money (part of M1), when depository institutions make loans, they do create money. This is not a gift from God, but the result of a fractional reserve system.

15. 8.If the Fed lowers the discount rate, ceteris paribus, what will happen to the monetary base? Does the Fed have absolute control over the volume of discount loans?

16. If the Fed lowers the discount rate, they are attempting to encourage more borrowing at the discount window. This should cause the volume of discount loans to be higher than what they otherwise would be. However, the Fed would most likely lower the discount rate when the economy was slowing or in a recession. Even with the lower rates, the volume of discount loans may not increase significantly because depository institutions may have excess reserves. Further, the Fed does not have absolute control over the volume of discount loans.

17. 9.If e increases given c and rD, how can the Fed offset this change in e? • The Fed can offset an increase in the excess reserve ratio with offsetting open market operations. In this case, if e increases, the money multiplier would fall and the Fed would use open market purchases to offset the effects of the smaller multiplier.

18. 10.If discount loans increase, what happens to the monetary base? • If discount loans increase, the monetary base increases by the amount of the increase in discount loans.

19. 11.What are the major assets and liabilities of the Fed? (Appendix)

20. The major assets and liabilities of the Fed are: • Assets • Gold certificate account • Special drawing rights certificate account • Coin • Loans • Acceptances held under repurchase agreements • Repurchase agreements—triparty • Federal agency obligations • U.S. Treasury securities • Items in process of collection • Bank premises • Other assets

21. Liabilities: • Federal Reserve notes • Reverse repurchase agreements—triparty • Total deposits • Depository institutions • U.S. Treasury—General account • Foreign—Official accounts • Other • Deferred credit items • Other liabilities and accrued dividends

22. Answers to Analytical Questions • 12.Assume that the Fed sets the required reserve ratio equal to 10 percent. If the banking system has $20 million in required reserve assets, what is the amount of checkable deposits outstanding?

23. Assuming that banks loan up, then total reserves would be equal to required reserves and the simple multiplier would be 10 (1/rD = 1/.1 = 10). In this case, checkable deposits would equal $200 million (10 x $20 million = $200 million)

24. 13.If rD = .25, what is the simple money multiplier? If reserves increase by $100, how much do deposits increase? • If rD = .25, then the simple money multiplier is 4. If reserves increase by $100, loans and deposits increase by $400 (4 x $100).

25. 14.If c = .35, rD = .10, and e = .10, what is the money multiplier? If a depository institution’s excess reserves increase by $400, how much can it safely lend? Ceteris paribus, how much money will the banking system create?

26. The money multiplier is 2.45 ((1 + .35)/(.10 +.35 +.10)). If a depository institution's excess reserves increase by $400, it can safely loan $400. Given a 2.45 multiplier, the banking system will create $980 (2.45 x $400).

27. 15.If c = .25, rD = .10, e = .05, and the Fed sells $100 in securities to the public, what happens to reserves, the monetary base, and the money supply after the change has worked its way through the entire banking system? Use T-accounts to explain your answer. • Reserves decrease • Monetary base decreases • Money supply decreases

28. Fed • Assets Liabilities •  + $100 (cash)+ $100 (securities) 

29. Public • Assets Liabilities •  +$100 (securities)+$100 (cash)  

30. 16.Using the same ratios as in question 15 and again using T-accounts, explain what happens to reserves, the monetary base, and the money supply if the Fed buys $100 in securities from the public. • Reserves increase • Monetary base increases • Money supply increases

31. Fed • Assets Liabilities •  + $100 (securities)+ $100 (cash) 

32. Public  • Assets Liabilities • +$100 (cash)+$100 (securities)

33. 17.In each of the following fictitious examples, tell whether the money multiplier will increase, decrease, or stay the same: • a. Depositors become concerned about the safety of depository institutions, and there is no deposit insurance. • b. Depository institutions do not see any creditworthy borrowers. • c. The Fed lowers the required reserve ratio. • d. Larger amounts of currency are demanded by the public to use in the “underground economy.” • e. Depository institutions believe that overall default risk has decreased.

34. a. Money multiplier decreases because c increases • b. Money multiplier decreases because e increases • c. Money multiplier increases because rD decreases • d. Money multiplier decreases because c increases • e. Money multiplier increases because e decreases

35. 18.Assume that a depository institution has excess reserves of $100 and the required reserve ratio is 10 percent. What is the amount of checkable deposits at the depository institution resulting from new loans based on the excess reserves? Why is this amount different from the maximum amount of $1,000 in checkable deposits that can be generated by the banking system as a whole?

36. The amount of checkable deposits at the depository institution resulting from new loans based on the excess reserves is $100. This amount is different from the maximum amount of $1,000 in checkable deposits that can be generated by the banking system as a whole because of the money multiplier effect. Any one bank can only safely lend its excess reserves. However, when the proceeds of the loan are deposited in another depository institution, that institution receives new excess reserves that serve as a basis for lending. The process continues until there are no more excess reserves in the system and all of the reserves are required reserves. Because of multiple rounds of lending, the banking system creates a much larger amount of checkable deposits than any one institution could.

37. 19.Suppose you find $100 in the attic of an old house you have just purchased. You deposit the $100 in your checking account at Bank of America. Use a T-account to show what happens to the bank’s assets and liabilities. What is the maximum amount Bank of America can lend from this deposit given a required reserve ratio of 10 percent?

38. Bank of America • Assets Liabilities • + $90 ER + $100 (deposit) • +$10 RR • The bank can loan out $90, which is its excess reserves.

39. 20.Suppose you withdraw $1,000 in cash from your Bank of America checking account for a weekend trip to Las Vegas. Use a T-account to show the impact on the bank’s assets and liabilities. Given a required reserve rate of 10 percent, what is the impact on bank lending?

40. Bank of America • Assets Liabilities • - $1,000 (reserves)- $1,000 (cash withdrawl) • Bank lending is reduced by the full amount of the loss in reserves, $1,000.

41. 21.By definition, narrow banking requires 100 percent reserve backing for checkable deposits. What is the money multiplier in this case? • Money multiplier = 1

42. 22.If M2 is $4 trillion and the monetary base is $500 billion, what is the M2 multiplier? (Appendix ) • M2 multiplier = 8 (M2/MB = $4 trillion/$500 billion = 8).