978-0134733821 Chapter 14 Solution Manual Part 1

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 158

Chapter 14

ANSWERS TO QUESTIONS

Unless otherwise noted, the following assumptions are made in all questions: the required reserve

ratio on checkable deposits is 10%, banks do not hold any excess reserves, and the public’s

holdings of currency do not change.

1. Classify each of these transactions as an asset, a liability, or neither for each of the

“players” in the money supply process—the federal reserve, banks, and depositors.

a. You get a $10,000 loan from the bank to buy an automobile.

b. You deposit $400 into your checking account at the local bank.

c. The Fed provides an emergency loan to a bank for $1,000,000.

d. A bank borrows $500,000 in overnight loans from another bank.

e. You use your debit card to purchase a meal at a restaurant for $100.

2. The First National Bank receives an extra $100 of reserves but decides not to lend out any of

these reserves. How much deposit creation takes place for the entire banking system?

3. Suppose the Fed buys $1 million of bonds from the First National Bank. If the First National

Bank and all other banks use the resulting increase in reserves to purchase securities only

and not to make loans, what will happen to checkable deposits?

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4. If a bank depositor withdraws $1,000 of currency from an account, what happens to

reserves, checkable deposits, and the monetary base?

5. If a bank sells $10 million of bonds to the Fed to pay back $10 million on the loan it owes,

what is the effect on the level of checkable deposits?

6. If you decide to hold $100 less cash than usual and therefore deposit $100 more cash in the

bank, what effect will this have on checkable deposits in the banking system if the rest of the

public keeps its holdings of currency constant?

7. “The Fed can perfectly control the amount of borrowed reserves in the banking system” Is

this statement true, false, or uncertain?

8. “The Fed can perfectly control the amount of the monetary base, but has less control over the

composition of the monetary base.” Is this statement true, false, or uncertain? Explain.

9. If credit risk in the banking system increases, all else equal what effect, if at all, will this

have on the money multiplier?

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 160

10. If lending rates that banks can charge increase, all else equal what effect, if at all, will this

have on the money multiplier?

11. “The money multiplier is necessarily greater than 1.” Is this statement true, false, or

uncertain? Explain your answer.

12. What effect might a financial panic have on the money multiplier and the money supply?

Why?

13. During the Great Depression years from 1930–1933, both the currency ratio c and the

excess reserves ratio e rose dramatically. What effect did these factors have on the money

multiplier?

14. In October 2008, the Federal Reserve began paying interest on the amount of excess reserves

held by banks. How, if at all, might this affect the multiplier process and the money supply?

15. The money multiplier declined significantly during the period 1930–1933 and also during the

recent financial crisis of 2008–2010. Yet the M1 money supply decreased by 25% in the

Depression period but increased by more than 20% during the recent financial crisis. What

explains the difference in outcomes?

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 161

ANSWERS TO APPLIED PROBLEMS

Unless otherwise noted, the following assumptions are made in all of the applied problems: the

required reserve ratio on checkable deposits is 10%, banks do not hold any excess reserves, and

the public’s holdings of currency do not change.

16. If the Fed sells $2 million of bonds to the First National Bank, what happens to reserves and

the monetary base? Use T-accounts to explain your answer.

Reserves and the monetary base fall by $2 million, as the following T-accounts indicate:

First National Bank

Assets

Liabilities

Reserves –$2 million

Securities +$2 million

Federal Reserve System

Assets

Liabilities

Securities –$2 million

Reserves –$2 million

17. If the Fed sells $2 million of bonds to Irving the Investor, who pays for the bonds with a

briefcase filled with currency, what happens to reserves and the monetary base? Use

T-accounts to explain your answer.

Reserves are unchanged, but the monetary base decreases by $2 million due to the currency

reduction, as the following T-accounts show:

Irving the Investor

Assets

Liabilities

Currency –$2 million

Securities +$2 million

Federal Reserve System

Assets

Liabilities

Securities –$2 million

Currency –$2 million

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 164

Assets

Liabilities

Securities +$2 million

Reserves –$2 million

After the decline in bank reserves, the multiple deposit creation process works in reverse, so

the final effect on the Fed and banking system balance sheets is shown below:

Federal Reserve System

Assets

Liabilities

Securities –$2 million

Reserves –$2 million

Banking System

Assets

Liabilities

Securities +$ 2 million

Checkable Deposits –$20 million

Reserves –$ 2 million

Loans –$20 million

21. If the Fed buys $1 million of bonds from the First National Bank, but an additional 10% of

any deposit is held as excess reserves, what is the total increase in checkable deposits?

(Hint: Use T-accounts to show what happens at each step of the multiple expansion process.)

Federal Reserve System

Assets

Liabilities

Securities +$1 million

Reserves +$1 million

Banking System

Assets

Liabilities

Securities –$1 million

Reserves +$1 million

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After the increase in reserves and the multiple deposit creation process, the Fed and Banking

system balance sheets are as follows:

Federal Reserve System

Assets

Liabilities

Securities +$1 million

Reserves +$1 million

Banking System

Assets

Liabilities

Securities –$1 million

Checkable Deposits +$5 million

Reserves +$1 million

Loans +$5 million

22. If reserves in the banking system increase by $1 billion because the Fed lends $1 billion to

financial institutions, and checkable deposits increase by $9 billion, why isn’t the banking

system in equilibrium? What will continue to happen in the banking system until equilibrium

is reached? Show the T-account for the banking system in equilibrium.

The banking system is still not in equilibrium because there continues to be $100 million of

excess reserves (+$1 billion of reserves minus $900 million of required reserves, 10% of the

$9 billion of deposits). The excess reserves will be lent out until equilibrium is reached with

an additional $1 billion of checkable deposits. The T-account for the banking system when it

is in equilibrium is as follows:

Banking System

Assets

Liabilities

Reserves +$ 1 billion

Loans (borrowings from the Fed) +$1 billion

Loans +$10 billion

Checkable deposits +$10 billion

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d. During the financial crisis in 2008, the Federal Reserve began injecting the banking

system with massive amounts of liquidity, and at the same time, very little lending

occurred. As a result, the M1 money multiplier was below 1 for most of the time from

October 2008 through 2011. How does this scenario relate to your answer to part (c)?

ANSWERS TO DATA ANALYSIS PROBLEMS

1. Go to the St. Louis Federal Reserve FRED database, and find the most current data

available on Currency (CURRNS), Total Checkable Deposits (TCDNS), Total Reserves

(RESBALNS), and Required Reserves (RESBALREQ).

a. Calculate the value of the currency deposit ratio c.

b. Use RESBALNS and RESBALREQ to calculate the amount of excess reserves, and then

calculate the value of the excess reserve ratio e. Be sure the units of total and required

reserves are the same when you do the calculations.

c. Assuming a required reserve ratio rr of 11%, calculate the value of the money multiplier m.

2. Go to the St. Louis Federal Reserve FRED database and find data on the M1 Money Stock

(M1SL) and the Monetary Base (AMBSL).

a. Calculate the value of the money multiplier using the most recent data available and the

data from five years prior.

b. Based on your answer to part (a), how much would a $100 million open market purchase

of securities affect the M1 money supply today and five years ago?

Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 168

Chapter 15

ANSWERS TO QUESTIONS

1. If the manager of the open market desk hears that a snowstorm is about to strike New York

City, making it difficult to present checks for payment there and so raising the float, what

defensive open market operations will the manager undertake?

2. During the holiday season, when the public’s holdings of currency increase, what defensive

open market operations typically occur? Why?

3. If the Treasury pays a large bill to defense contractors and as a result its deposits with the

Fed fall, what defensive open market operations will the manager of the open market desk

undertake?

4. If float decreases to below its normal level, why might the manager of domestic operations

consider it more desirable to use repurchase agreements to affect the monetary base, rather

than an outright purchase of bonds?

5. “The only way that the Fed can affect the level of borrowed reserves is by adjusting the

discount rate.” Is this statement true, false, or uncertain? Explain your answer.