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16. Suppose that a bond having no expiration date has a face value of $10,000 and pays a fixed amount of interest of
$1000 annually. Compute and enter in the spaces provided either the effective interest rate which a bond buyer
could receive at the new price or the bond price (rounded to the nearest $1000) required to receive the interest rate
shown.
Bond price
Interest rate
(%)
$_____
12.5
9,000
_____
_____
10.0
_____
8.3
15,000
_____
Bond price
Interest rate
(%)
$ 8,000
12.5
9,000
11.1
10,000
10.0
12,000
8.3
15,000
6.67
17. Why is the money demand curve downsloping?
We know that the transaction demand curve is a vertical line. This occurs because at a certain nominal GDP,
18. Suppose an increase in aggregate demand raises the price level. What would be the effect on the total money
demand curve?
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19. Suppose you have a $2000 bond that makes an annual interest payment of $75. Use this information to answer
the following questions.
(a) Suppose the current interest rate is 6%. What would be the market price of the bond?
(b) Suppose the current interest rate fell to 3.75%. What would be the market price of the bond?
(c) Suppose the current interest rate fell even further to 2%. What would be the market price of the bond?
20. Identify the major items in the consolidated balance sheet of the Federal Reserve Banks.
21. Identify the four major instruments of monetary policy.
The four major instruments of monetary policy are open-market operations, including repo and reserve repo
transactions, changing the reserve ratio, changing the discount rate on loans that the Federal Reserve makes to
22. What are the four principal tools of monetary policy? Explain how they can be used.
The Federal Reserve Banks use four principal tools (techniques or instruments) to control the reserves of banks
and the size of the money supply. (1) The Federal Reserve can buy or sell government securities in the open
market to change the lending ability of the banking system: (a) buying government securities in the open market
23. What is the difference between the Federal Reserve Banks’ purchases of securities from the commercial banking
system and those from the public? Give an example.
Assume that the commercial banks are “loaned up.” Purchases of bonds by the Fed from commercial banks
increase actual reserves and excess reserves of the commercial banks by the full amount of the bond purchase.
Purchases of bonds by the Fed from the public increase actual reserves, but also increase checkable deposits.
24. Both Federal Reserve Banks and commercial banks buy and sell government securities, but for substantially
different reasons. Explain.
25. Explain the impact of each of the following upon commercial bank reserves: (a) the Federal Reserve sells
government bonds in the open market to private buyers; (b) the commercial banks reduce their indebtedness to the
Federal Reserve Banks; (c) the Treasury makes a number of large disbursements in accelerating space research.
26. Explain what is meant by a collateralized money loan. Provide an example.
27. Discuss how repos and reverse repos can be used to increase or decrease the money supply.
To increase the money supply the Federal Reserve can issue a repo transaction. The Federal Reserve will loan
money in exchange for government bonds being posted as collateral. The bank now has access to additional
28. (Consider This) Explain what is meant by the Federal Reserve’s collateralized transactions known as repos and
reverse repos. How are these different than traditional open-market operations?
29. Explain how a change in the reserve ratio affects the money supply.
30. What is the discount rate and how does changing it affect the money supply?
The discount rate is the interest rate the Fed charges when it makes short term loans to banks. Borrowing from the
Fed increases a bank’s reserves, increasing their lending ability and thus increasing the money supply. An
increase in the discount rate makes this kind of borrowing more expensive for banks, decreasing the demand for
31. Explain how a change in the interest rate on reserves affects the money supply.
An increase in the interest rate on reserves will strengthen the incentive for banks to save their reserves and
increase the excess reserves held by commercial banks, thus causing the money supply to decrease. A decrease in
the interest rate on reserves will encourage banks to make loans, thus causing the money supply to increase.
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32. Following are the consolidated balance sheets of the commercial banks. Assume that the reserve ratio for banks is
10%. The figures in column 1 show the balance sheets’ condition prior to each of the following five transactions.
Place the new balance-sheet figures in the appropriate columns and complete A, B, C, D, and E for each column.
Start each part (2–6) with the figures in column 1. All figures are in billions of dollars.
(1)
(2)
(3)
(4)
(5)
(6)
Assets:
Reserves $ 50
Securities 70
Loans 90
Liabilities:
Checkable deposits 200
Loans from Federal Reserve 10
A. Required reserves
B. Excess reserves
C. Change in M1
D. How much more can M1 change?
E. C + D total
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
_____
_____
_____
_____
_____
(a) Show in column 2 the initial results of the Federal Reserve selling $3 billion in securities to the public which
pays by checks.
(b) Show in column 3 the initial results of the Federal Reserve buying $4 billion in securities from the
commercial banks.
(c) Show in column 4 the initial results of the Federal Reserve raising the reserve ratio to 20%.
(d) Show in column 5 the initial results when the U.S. Government buys $5 billion worth of goods from
American businesses with checks from the U.S. Treasury account at the Federal Reserve Banks and the
businesses immediately deposit these checks in their commercial banks.
(e) Show in column 6 the initial results when the Federal Reserve raises the discount rate which causes
commercial banks to repay $6 billion in loans owed to the Federal Reserve.
(1)
(2)
(3)
(4)
(5)
(6)
Assets:
Reserves $ 50
Securities 70
Loans 90
Liabilities:
Checkable deposits 200
Loans from Federal Reserve 10
A. Required reserves
B. Excess reserves
C. Change in M1
$ 47
70
90
197
10
19.7
27.3
−3
$ 54
66
90
200
10
20
34
0
$ 50
70
90
200
10
40
10
0
$ 55
70
90
205
10
20.5
34.5
5
$ 44
70
90
200
4
20
24
0
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33. The following are simplified balance sheets for the commercial banking system and the Federal Reserve system.
Perform each of the following three transactions, a, b, and c, making appropriate changes in columns (1) through
(3) in each balance sheet. Do not cumulate your answers. Also, answer these three questions for each part: (a)
What change, if any, took place in the money supply as a direct result of this transaction? (b) What change, if
any, occurred in commercial bank reserves? (c) What change occurred in the money-creating potential of the
commercial banking system if the reserve ratio is 20%? All figures are in billions of dollars.
Consolidated Balance Sheet: Commercial Banking System
(1)
(2)
(3)
Assets:
Reserves $ 45
Securities 80
Loans 80
Liabilities:
Checkable deposits 200
Loans from FRBs 5
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
Consolidated Balance Sheet: Federal Reserve Banks
(1)
(2)
(3)
Assets:
Securities $80
Loans to CBs 5
Liabilities:
Reserves of CBs 45
Treasury deposits 5
Federal Reserve notes 35
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
(a) Suppose a drop in the discount rate causes commercial banks to borrow an additional $2 billion from the Fed.
Show the new sheet figures in column 1.
(b) The Fed buys $3 billion of government bonds from the public. Show the new sheet figures in column 2.
(c) The Treasury spends $1 billion on research on new farm products. Show the new figures in column 3.
Consolidated Balance Sheet: Commercial Banking System
(1)
(2)
(3)
Assets:
Reserves $ 45
Securities 80
Loans 80
Liabilities:
Checkable deposits 200
Loans from FRBs 5
($47)
80
80
200
(7)
($48)
80
80
(203)
5
($46)
80
80
(201)
5
Consolidated Balance Sheet: Federal Reserve Banks
(1)
(2)
(3)
Assets:
Securities $80
Loans to CBs 5
Liabilities:
$80
(7)
($83)
5
$80
5
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McGraw-Hill Education.
Reserves of CBs 45
Treasury deposits 5
Federal Reserve notes 35
(47)
5
35
(48)
5
35
(46)
(4)
35
(a) No direct change in the money supply; bank reserves up by $2 billion; money-creating potential up by $10
billion (5 times $2 billion).
(b) Money supply up by $3 billion; bank reserves up by $3 billion; money-creating potential up by 5 times $2.4
(excess reserves) = $12 billion.
(c) Money supply up by $1 billion; bank reserves up by $1 billion; money creating potential up by 5 times $.8 =
$4 billion. (Assumes $1 billion comes from account in Fed.)
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34. The following are simplified balance sheets for the commercial banking system and the Federal Reserve System.
Perform each of the following three transactions, a, b, and c, making appropriate changes in columns (1) through
(3) in each balance sheet. Do not cumulate your answers. Also, answer these three questions for each part: (a)
What change, if any, took place in the money supply as a direct result of this transaction? (b) What change, if
any, occurred in commercial bank reserves? (c) What change occurred in the money-creating potential of the
commercial banking system if the reserve ratio is 20%? All figures are in billions of dollars.
Consolidated Balance Sheet: Commercial Banking System
(1)
(2)
(3)
Assets:
Reserves $ 50
Securities 75
Loans 75
Liabilities:
Checkable deposits 190
Loans from FRBs 10
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
Consolidated Balance Sheet: Federal Reserve Banks
(1)
(2)
(3)
Assets:
Securities $90
Loans to CBs 10
Liabilities:
Reserves of CBs 50
Treasury deposits 10
Federal Reserve notes 10
$_____
_____
_____
_____
_____
$_____
_____
_____
_____
_____
$____
_
_____
_____
_____
_____
(a) Suppose a drop in the discount rate causes commercial banks to borrow an additional $3 billion from the Fed.
Show the new sheet figures in column 1.
(b) The Fed buys $2 billion of government bonds from the public. Show the new sheet figures in column 2.
(c) The Treasury spends $1 billion on research on new farm products. Show the new sheet figures in column 3.
Consolidated Balance Sheet: Commercial Banking System
(1)
(2)
(3)
Assets:
Reserves $ 50
Securities 75
Loans 75
Liabilities:
Checkable deposits 190
Loans from FRBs 10
($53)
75
75
190
(13)
($52)
75
75
(192)
10
($51)
75
75
(191)
10
Consolidated Balance Sheet: Federal Reserve Banks
(1)
(2)
(3)
Assets:
Securities $90
Loans to CBs 10
Liabilities:
Reserves of CBs 50
Treasury deposits 10
Federal Reserve notes 10
$90
(13)
(53)
10
40
($92)
10
(52)
10
40
$90
10
(51)
(9)
40
(a) No direct change in the money supply; bank reserves up by $3 billion; money-creating potential up by $15
billion.
(b) Money supply up by $2 billion; bank reserves up by $2 billion; money-creating potential up by 5 $1.6 = $8
billion.
(c) Money supply up by $1 billion; bank reserves up by $1 billion; money-creating potential up by 5 times $.8 =
$4 billion.
35. Which tool of monetary policy is most important? Why?
36. What interest rate has been the focus of monetary policy?
37. What is the relationship between the Federal funds rate and the prime interest rate? Why doesn’t the Federal
Reserve target the prime interest rate?
38. Describe how the usefulness of the Federal Funds Rate has changed from before the financial crisis to after.
39. Compare and contrast expansionary monetary policy prior to and after the financial crisis.
Prior to the financial crisis the Federal Reserve’s primary tool of monetary policy was open-market operations. By
using open market operations the Federal Reserve could increase and decrease the amount of excess reserves
available in the federal funds market. In doings so they would target the federal funds rate, and in turn influence
loans consumers and businesses receive.
40. Compare and contrast restrictive monetary policy prior to and after the financial crisis.
Prior to the financial crisis the Federal Reserve would respond to economy “overheating” or inflation by reducing
aggregate demand and lowering the rate of inflation. To do this the Federal Reserve almost exclusively used open
market operations. The Fed would sell bonds to banks and the public, reducing the amount of reserves in the
system. A reduced number of reserves would have two effects: 1) the supply of federal funds would decrease,
increasing the federal funds rate, 2) This would in turn influence other interest rates (consumer and business),
reducing consumption and investment spending, restricting aggregate demand and lowering the inflation rate.
41. Define the Taylor rule.
The Taylor rule is a rule of thumb used by the Federal Reserve to target the Federal funds rate. The Taylor rule
assumes a target inflation rate of 2% and has three parts. First, if real GDP rises by 1% above potential GDP, the
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42. How does monetary policy affect equilibrium GDP? How can it address the problem of recession or slow
growth? Inflation?
44. Use the below graphs to answer the following questions assuming the nominal GDP in the economy is given.
(a) Look at graph A and suppose the supply of money increases from 100 to 200. What will be the equilibrium
rate of interest?
(b) Look at graph B which shows an investment-demand curve for this economy. Given the answer to part (a)
above, how much will investors plan to spend on capital goods?
(c) What will happen to aggregate demand?
(d) Now trace what will happen in parts (a)–(c) if the money supply increases to $300.
45. Trace the cause-effect chain that results from an expansionary monetary policy.
46. Trace the cause-effect chain that results from a restrictive monetary policy.
A restrictive monetary policy will cause bank reserves to decline and the money supply to decrease. Interest rates
47. Differentiate between expansionary and restrictive monetary policies.
48. Suppose the economy is experiencing a recession and high unemployment. What would be the interpretation of
how an expansionary monetary policy would address this problem?
49. Suppose the economy is experiencing inflation. What would be the interpretation of how a restrictive monetary
policy would address this problem?
50. Discuss the relative merits of monetary policy under conditions of demand-pull inflation or recession.
51. Explain two strengths of monetary policy for achieving economic stability.
Monetary policy is relatively speedy and flexible relative to fiscal policy because the decision-making body is
52. What are the political and economic limitations upon (a) fiscal policy and (b) monetary policy?
Political limitations on fiscal policy are the strongest because tax and spending policies are designed and ratified
53. How did the Fed use the Federal funds rate to respond to the mortgage default crisis?
54. One of the advantages of monetary policy is its speed and flexibility, but there are limitations. Explain.
55. Explain what is meant by cyclical asymmetry with regard to monetary policy effects.
56. What are the implications of a liquidity trap for the Federal Reserve?
57. Discuss the various monetary policy actions taken by the Federal Reserve to deal with the problems occurring in
the economy during the Great Recession.
58. Explain the “big picture” of macroeconomics based on the components of aggregate supply and aggregate
demand.
59. (Last Word) Examine the consequences of negative interest rates that occurred due to actions taken by the
European Central Bank after the financial crisis.
