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CHAPTER 24

By Chris Martinez,2014-10-30 20:26
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CHAPTER 24

    CHAPTER 11

    THE BANKING SYSTEM AND THE MONEY SUPPLY

    ANSWERS TO EVEN-NUMBERED ONLINE REVIEW QUESTIONS

     2. M1 includes cash in the hands of the public, demand deposits, other checking

    account deposits, and travelers checks. M2 includes cash in the hands of the

    public, demand deposits, other checking account deposits, travelers checks,

    savings-type accounts, retail MMMF balances, and small denomination time

    deposits.

     4. Net worth is listed on the liabilities side of a balance sheet because it is, in a sense,

    what the bank would owe to its owners if it went out of business.

     6. The important difference between the Board of Governors and the FOMC is that

    the FOMC has the important task of establishing U.S. monetary policy, while the

    Board of Governors supervises and regulates member banks, supervises the 12

    Federal Reserve District Banks, and sets reserve requirements and approves the

    discount rate.

     8. When the Fed wants to increase the money supply, it purchases bonds from a

    bond dealer, and pays with a Federal Reserve check. When the bond dealer

    deposits the check in its bank account, it counts as reserves for the bank. The bank

    has excess reserves, which it lends out. The reserves will find their way to another

    bank, leading to excess reserves at that bank, and so on. Each time a bank obtains

    new reserves and lends out the excess, it ends up with more deposits than it

    started with. As the process continues, the total quantity of demand depositsand

    with it the money supplyincreases.

    When the Fed wants to decrease the money supply, it sells bonds to a bond

    dealer, and makes the bank pay with reserves. The bank has deficient reserves, so

    it must decrease its volume of loans, and decrease the volume of its deposits at the

    same time. As loans are paid back to this bank, some other bank in the system will

    develop deficient reserves, and have to decrease the volume of its loans and

    deposits, and so on. As the process continues, the total quantity of demand

    depositsand with it, the money supplydecreases.

     10. Governments have more than one measure of the money supply because

    measuring the money supply is harder than it might seem. For example, while you

    can’t use funds in a savings account to buy things directly, you can easily move

    those funds into a checking account, so the question arises as to whether savings

    account balances are money.

    12. Banks cannot create wealth when they create money. ―Creating money‖ is

    different from ―creating wealth.‖ When a bank creates money by giving someone

    a loan, that person has extra money in his account, but owes the same amount to

    the bank. The net change in their wealth is $0.

2 Even-Numbered Answers for Economics: Principles and Applications, 4e

    EVEN-NUMBERED PROBLEM SET

    2. The money supply can increase by a maximum of (1/0.15) x $50 million =

    $333.33 million. If the required reserve ratio is 0.18, the money supply can

    increase by a maximum of (1/0.18) x $50 = $277.78 million.

    4. M1 = cash in hands of public + demand deposits + other checkable deposits +

    travelers’ checks = $400 billion + $400 billion + $250 billion + $10 billion =

    $1,060 billion.

    6. With no excess reserves, each dollar of reserves supports 1/RRR in demand

    deposits. Initially, with the required reserve ratio of 0.2, $200 billion in reserves

    supports $200 billion x (1/0.20) = $1,000 billion in demand deposits. To decrease

    demand deposits by $50 billion (to $950 billion), solve this equation for RRR:

    $950 = (1/RRR) x $200 billion ? RRR = 0.21.

     The Fed must increase the required reserve ratio to 0.21.

     8. To find the answer, substitute the desired change in the money supply ($500

    billion) and the demand deposit multiplier (10 = 1/0.10) into the equation for the

    change in the money supply, and solve for the change in reserves:

    $500 billion = 10 x ?Reserves ? ?Reserves = $500 billion/10 = $50 billion

    The Fed will need to increase initial deposits by $50 billion. It can do this by

    buying government bonds worth $50 billion from the public.

    If the required reserve ratio is 0.15 (so that the demand deposit multiplier = 1/0.15

    = 6.67), the Fed will need to increase initial deposits by $500 billion/(6.67) =

    $74.96 billion. It can do this by buying government bonds worth $74.96 billion

    from the public.

     10. a.

    First National Bank

    Assets Liabilities

Fed buys bond, +$1,000 in reserves +$1,000 in demand deposits

    Bond seller deposits

    The Fed’s check: Bank makes loan: $800 in reserves

     +$800 in loans Total effect: +$200 in reserves +$1,000 in demand deposits

     +$800 in loans

    3 Chapter 24

    Second United Bank

    Assets Liabilities

    Borrower deposits

    $800 loan: +$800 in reserves +$800 in demand deposits

    Bank makes loan: $640 in reserves

     +$640 in loans

    Total effect: +$160 in reserves +$800 in demand deposits

     +$640 in loans

    Third State Bank

    Assets Liabilities Borrower deposits

    $640 loan: +$640 in reserves +$640 in demand deposits

    Bank makes loan: $512 in reserves

     +$512 in loans

    Total effect: +$128 in reserves +$640 in demand deposits

     +$512 in loans

    b. When the Fed buys the $1,000 bond, and its check is deposited at First

    National Bank, the money supply increases by $1,000 (since $1,000 in

    demand deposits that didn’t exist before have been created). When First

    National Bank lends out $800 in reserves, the money supply increases by

    another $800. When Second United lends out $640 and Third State lends out

    $512, the money supply increases by $640 and $512, respectively.

    c. In the end, demand deposits will rise by $1,000 ? (1/0.2) = $5,000. 12. a. The Fed will have to reduce the required reserve ratio.

     b. The Fed will have to increase the required reserve ratio.

    4 Even-Numbered Answers for Economics: Principles and Applications, 4eMORE CHALLENGING QUESTIONS

     14. a. The effects of the Fed’s purchase of a $100,000 bond, when banks hold excess

    reserves equal to 5% of deposits, and the required reserve ratio is 0.1:

    Bank #1

    Assets Liabilities

    Fed buys bond, +$100,000 in reserves +$100,000 in demand deposits Bond-seller deposits

    The Fed’s check:

    Bank makes loan: $85,000 in reserves

     +$85,000 in loans

    Total effect: +$15,000 in reserves +$100,000 in demand deposits

     +$85,000 in loans

    Bank #2

    Assets Liabilities

    Borrower deposits

    $85,000 loan: +$85,000 in reserves +$85,000 in demand deposits

    Bank makes loan: $72,250 in reserves

     +$72,250 in loans

    Total effect: +$12,750 in reserves +$85,000 in demand deposits

     +$72,250 in loans

    Bank #3

    Assets Liabilities

Borrower deposits

    $72,250 loan: +$72,250 in reserves +$72,250 in demand deposits

    Bank makes loan: $61,412.50 in reserves

     +$61,412.50 in loans

    Total effect: +$10,837,50 in +$72,250 in demand deposits reserves

     +$61,412.50 in loans

    b. In this case, each bank lends out 85% of the deposits it receives, so that the 2 3money multiplier is 1 + 0.85 + 0.85+ 0.85 + … = 1/(1 – 0.85) = 1/0.15 =

    6.66. The demand deposit multiplier is smaller than in the case when banks

    5

    hold no excess reserves. With an RRR = 0.1, and no holding of excess reserves,

    the demand deposit multiplier was 1/0.1 = 10. Chapter 24 The ultimate change in demand deposits will be $100,000 ? 6.66 = $666,666.

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