173
PART FIVE: ECONOMIC POLICY
CHAPTER 16: MONEY, THE BANKING SYSTEM, AND
INTEREST RATES
Additional Questions
ESSAY QUESTIONS AND/OR PROBLEMS:
1. For these questions, suppose that the reserve requirement for checking deposits is 25%, that
banks do not hold any excess reserves, and that the public does not change their holdings of
currency. Total reserves already existing in the banking system are $300 million.
(a). What is the money supply in this economy?
(b). If the Fed sells $4 million of T-Bonds, what is the change in the economy’s money
supply?
(c). If the Fed would reduce the reserve requirement to 20%, what would be the change in
the money supply?
(d). If the Fed reduced the reserve requirement ratio to 20% but banks preferred to hold the
extra 5% as excess reserves, what would be the change in the money supply?
2. Assume that banks hold no excess reserves and the public does not change their currency
holdings. If currency is $800, total bank reserves are $2,000, and checkable deposits are
$20,000, then
(a). what is the monetary base?
(b). what is the money supply?
(c). if the required reserve ratio is 10% and banks hold no more excess reserves, then what
will the money supply be if the Fed increases total bank reserves by $100?
3. What tools can the Federal Reserve use to control the monetary base? Explain the way in
which changes in each tool affect the level of bank reserves. Which tool do they choose to
use on a day-to-day basis, and why?
174 CHAPTER 16
4. What is the effect of a Federal Reserve open market sale? What happens to interest rates in
the money market and federal funds market as a result? Provide a graph of the money
market and federal funds market to illustrate.
5. If you write a check for $100 to your roommate who immediately deposits it, what is the
maximum amount of change in the money supply?
6. “In the real world, if the reserve requirements on checkable deposits were set at zero, the
amount of multiple deposit expansion would go on indefinitely.” Is this true or false?
Explain.
7. What are the three functions of money? Which of these functions are emphasized in the
classical and Keynesian models? Also, discuss how inflation reduces the efficiency by
which money serves each of these functions.
8. Who are the two monetary policymaking groups located in Washington? What are their
functions?
9. Explain the way in which the value of the money multiplier and the money supply would
be affected by each of the following:
(a). a rise in the public’s desired ratio of currency to checkable deposits.
(b). a fall in the banking system’s desired excess reserve to checkable deposits ratio.
10. Suppose that the balance sheet of Local State Bank is as follows:
ASSETS LIABILITIES
Reserves $15,000 Checkable deposits $20,000
Loans $4,000
Bonds $1,000
(a). If the required reserve ratio is 10%, what is the maximum amount of new loans that this
bank can create? Explain.
(b). If a depositor withdraws $2,000, now what is the maximum amount of new loans that
this bank can create? Explain.
(c). Suppose that the Fed sells $1,000 of T-bonds to the Local State Bank. Show what
happens to Local State Bank’s balance sheet. What happened to the monetary base?
Additional Essay Questions and/or Problems:
11. Suppose that the Federal Reserve sells government securities in the open market. Trace the
linkages through which this action will affect the money stock, level of interest rates, and
level of economic activity.
12. Is it possible for the Federal Reserve to set and achieve target levels for both the money
stock and the interest rate? Why or why not?
13. Monetarists, including Milton Friedman, have argued that central banks have been the
cause of all recessions and expansions. As evidence of this, they note that M1 is strongly
positively correlated with output. Based on your knowledge of the money creation process,
do you think that there could be an alternative explanation to this argument?
14. Explain the difference between the discount rate and the federal funds rate. Which does the
Fed directly control? Which has the most impact on the banking system, and why?
15. Analyze the following statement: “The money supply fell quite dramatically during the
Great Depression. Thus, the Federal Reserve was actively responsible for the fall in income
that occurred.”
16. The Fed has recently begun to pay interest on all reserves (required and excess) held at the
Fed. What impact would this have on the money supply and the federal funds rate if the Fed
did this in isolation (without any other changes in monetary policy)? Explain.
17. Define the concept of “quantitative easing”. In what ways is it different from traditional
open market operations? In what ways is it similar.
18. For these questions, assume the reserve requirement ratio is 20%, or r=.20.
a. If C = $1,500B, D = $2,500B, ER = $100B, what is the monetary multiplier, the
monetary base, and M1?
b. If the Fed conducts a $80M open market purchase, what happens to the monetary base
and the money supply?
c. How would your answer to (b) change if the Fed conducted a $80M open market
purchase but depositors immediately withdraw $50M of this and hold it as currency?
Multiple-Choice Questions:
1. The monetary base consists of
2. Which of the following functions express the money multiplier (m) for the narrowly
defined money stock (M1)?
3. If the Federal Reserve sells $10 million in government securities in the open market, with a
10 percent required reserve ratio on deposits, the maximum increase in deposits would be
4. The most commonly used tool by the Federal Reserve to control the monetary base is
5. If commercial banks hold checkable deposits of $100,000, reserves of $30,000, and the
required reserve ratio is 20 percent, what is the maximum additional amount by which the
banking system can expand the money supply?
6. If the Federal Reserve purchases $1 million in government securities in the open market,
with a 25 percent required reserve ratio on deposits, the maximum increase in deposits
would be
7. Assuming each policy is performed with the same magnitude, which of the following
would be the most restrictive monetary policy action on the part of the Federal Reserve?
8. The Federal reserve prefers to use open market operations because
9. Assuming the required reserve ratio is 20 percent and total reserves are set at $20 billion,
10. If the Federal Reserve were to simultaneously sell government bonds in the open market
and decrease the discount rate, the
11. If you write a check on your checking account to pay your rent which your landlord
deposits in a bank, then
12. Which of the following is the largest asset on a consolidated balance sheet for a commercial
bank?
13. If the Federal Reserve increases the legal reserve requirement on deposits,
14. If the Federal Reserve raises the discount rate, the market rate of interest
15. Which of the following is not a function of the Fed?
16. The federal funds market is the market for
17. A member of the Board of Governors of the Federal Reserve is appointed by
18. The Open Market Committee is composed of
19. The Federal Open Market Committee is responsible for directing
20. In the Keynesian model, a Federal Reserve sale of government securities in the open
market will
21. If a fear of increased bankruptcies of firms causes banks to increase their reserve to deposit
ratio, then
22. Legal reserve requirements specify that banks must hold a certain percentage of their
deposit liabilities
23. If the Fed follows a policy of fixed exchange rates, an undervalued dollar will force the Fed
to
24. The federal funds interest rate
25. Which would be a liability on a balance sheet of a commercial bank?
26. The money supply is determined
27. If the money supply is $1 billion, the reserve requirement is 10%, and currency holding $50
million, then reserves are
28. Which of the following statements is (are) correct?
29. Since reserve requirements on time and savings deposits were phased out in the early
1990s,
30. Assuming an increase in money demand, then if the Federal Reserve
31. Which of the following statements is (are) correct? The Federal Reserve
32. Which of the following would be an asset on a consolidated balance sheet for a commercial
bank?
33. The portion of the money supply controlled by a central bank is
34. If the money supply is $200 million, the reserve requirement is 20%, and currency holding
$10 million, then reserves are
35. If the reserve requirement decreases from 20% to 25% and the currency to deposit ratio
increases from 10% to 15% then
36. The money multiplier is the ratio of
37. An open market purchase immediately impacts the banking system balance sheet by
38. Which of the following variables that affect the money stock are outside the direct control
of the Federal Reserve?
39. Which of the following will lower the money multiplier?
40. During the Great Depression, the money supply fell 28%. During that same time, the
monetary base ____ and the currency-to-deposit ratio and reserve-to-deposit ratios both
_____.
41. Assume the Federal Reserve increases the required reserve ratio from 10 to 20 percent and
reserves are $80 billion. Then the change in the money supply will be
42. Assume that the Federal Reserve has purchased a $1,000 security from an individual, the
required reserve ratio is 20 percent, and that individual deposits the proceeds in his bank.
What is the increase in excess reserves for this bank?
43. In the United States there were legal reserve requirements on time and savings deposits
during most of the post-World War II period. Therefore, the money multiplier for the M1
definition was
44. If the Federal Reserve simultaneously sells government bonds in the open market and raises
reserve requirements, the
45. Primary assets held by the Federal Reserve are
46. Primary liabilities of the Federal Reserve include
47. If many banks fail, this is likely to cause a/an
48. With the invention of ATM machines, the public now holds less currency. As a result, we
would expect to have seen
49. The fall in the money multiplier and money supply during the Great Depression
50. “Lender of last resort” means that the central bank
51. The Board of Governors of the Federal Reserve System is responsible for
52. Assuming the Federal Reserve makes an open-market purchase of a government security
worth $10,000. By writing a check to pay for this security, the Federal Reserve
53. A fall in which of the following would increase the money multiplier?
54. A critical assumption for the simple money multiplier (1/ rrd) to hold is that
55. Assuming a decrease in money demand, then to keep interest rates constant the Fed must
56. Fiat money is:
58. Why did the money supply fall during the Great Depression?
59. If the monetary base doubles but the ratios of currency/deposit and reserves/deposits remain
the same, then:
60. An increase in the required reserve ratio will lead to a/an: