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Chapter 17
The Central Bank Balance Sheet
and the Money Supply Process
Conceptual and Analytical Problems
1. Follow the impact of a $100 cash withdrawal through the entire banking system,
assuming that the reserve requirement is 10 percent and that banks have no desire
to hold excess reserves. (LO3)
Answer: Deposits fall by $100 and reserves fall by $100. The bank (Bank A)
needs to increase its reserves by $90 in order to meet the required reserve ratio.
This continues until deposits contract by $100/0.1 = $1,000.
2. Suppose a major bank needs to borrow $20 billion overnight that it cannot obtain
provided that it will not alter interbank lending rates. How can it do so? (LO1)
Answer: The Fed can make the $20 billion loan to the problem bank if it
simultaneously sells $20 billion of securities to the rest of the banking system.
the securities by drawing down their reserve accounts.
3. Compute the impact on the money multiplier of an increase in the
currency-to-deposit ratio from 10 percent to 15 percent when the reserve
requirement is 10 percent of deposits, and banks’ desired excess reserves are 3
percent of deposits. (LO3)
Answer:
78.4
03.01.01.0
1.01
4. Does the Federal Reserve frequently purchase or sell gold or foreign exchange as
part of its efforts to change the money supply? (LO1)
Answer: No. Fed transactions in foreign exchange and gold are infrequent, and
are not used to alter the money supply. The Fed usually purchases and sells
price of gold.
5. Consider an open market purchase by the Fed of $3 billion of Treasury bonds.
ratio is 10 percent; (2) the bank does not wish to hold excess reserves; and (3) the
public does not wish to hold currency. (LO3)
Answer: The bank’s securities fall by $3 billion and its reserves rise by $3 billion.
multiplier will be 1/0.1=10, so the value of deposits (and M1) will rise by $30
billion.
6. When you withdraw cash from your bank’s ATM, what happens to the size of the
Fed’s balance sheet? Is there any reason for the Fed to react to your action? (LO1)
Answer: The reserves held by your bank at the Fed decline, but there is a larger
may choose to alter policy to offset the impact on the money supply.
7. *Why is currency circulating in the hands of the nonbank public considered a
liability of the central bank? (LO1)
Answer: Currency issued by the central bank is effectively an IOU to the holder
of the currency. The central bank is obliged to pay back the holder of the
central bank is obliged only to exchange currency for more currency.
8. How did the financial crisis of 2007–2009 affect the size and composition of the
balance sheet of the Federal Reserve? (LO1)
Answer: Between December 2007 and December 2009, the assets on the Federal
Reserve’s balance sheet increased by 2.5 times, mostly in the form of securities.
Fed as banks held on to excess reserves. At times, the Treasury also increased its
deposits at the Fed to help the Fed limit the increase of bank reserves as its assets
rose.
9. Suppose the currency-to-deposit ratio is 0.25, the excess reserve-to-deposit ratio is
money multiplier: a rise of 0.05 in the currency ratio or in the excess reserves
ratio? (LO4)
Answer: Initially, the money multiplier is
m =
13.3
05.010.025.0
25.01
If the currency-to-deposit ratio rises to 0.30, the multiplier falls to
m =
89.2
05.010.030.0
30.01
If, instead, the excess reserve-to-deposit ratio rises, the multiplier will be
m =
78.2
10.010.025.0
25.01
So, multiplier falls by more with the increase in the excess reserve ratio.
10. Is the money-multiplier model still useful for policymakers in the United States?
If not, why not? (LO4)
Answer: Since the financial crisis began in 2007, the model has been of limited
use for policymakers. The reason is that the ratios to deposits of currency and
excess reserves – the terms in the multiplier that are beyond the control of the
central bank – have become unstable. Consequently, the central bank can no
11. Based on Figure 17.10, explain why the multipliers fell sharply with the onset of
the financial crisis of 2007–2009. Why did they remain at this lower level after
the crisis ended? (LO3)
Answer: The money multipliers plummeted during the financial crisis as banks
hoarded excess reserves in the face of the liquidity crisis. Confronted with the
reserves fell, so banks continued to hold these excess reserves even as the crisis
receded. Consequently, the multiplier remained low.
12. The U.S. Treasury maintains accounts at commercial banks. What would be the
consequences for the money supply if the Treasury shifted funds from one of
those banks to the Fed? (LO2)
Answer: The balance sheet for the bank would reflect a decrease in reserves and a
decrease in deposits. The decrease in reserves would also appear on the Fed’s
would be a decline in the quantity of money.
13. *Explain how an incomplete understanding at the Federal Reserve of the
financial crisis of 2007–2009 illustrate that it had learned a valuable lesson from
the Great Depression? (LO4)
Answer: During the Great Depression, the central bank was increasing the
monetary base at a significant rate. Conditions in the economy and the banking
2007–2009, the Fed rapidly expanded the supply of reserves, preventing a
collapse of the money supply like that seen in the 1930s.
14. Suppose you examine the central bank’s balance sheet and observe that since the
activity did the central bank carry out earlier in the day to lead to these changes in
the balance sheet? (LO3)
Answer: The central bank conducted an open market sale of $100 million with a
commercial bank. The sale of the securities would involve $100 million of
fall of $100 million in reserves on the central bank balance sheet.
15. Do you think the central bank was aiming to increase, decrease, or maintain the
size of the money supply by carrying out the changes described to its balance
sheet in Problem 14? Explain your answer. (LO4)
Answer: It is most likely that the central bank was aiming to decrease the money
unchanged, this would decrease the money supply.
16. Looking again at the situation described in Problem 14, do you think the size of
changes to the central bank’s balance sheet? Explain your answer. (LO2)
Answer: No. Reserves and securities both appear on the asset side of the balance
sheet of the banking system, so their offsetting changes would affect the
composition but not the size of its balance sheet. Over time, the banking system
17. Do you think the Federal Reserve successfully carried out its role as lender of last
resort in the wake of the terrorist attacks on September 11, 2001? Why or why
not? (LO2)
Answer: Yes. The Fed successfully acted as lender of last resort and prevented
Fed stepped in and provided huge amounts of liquidity to enable banks to meet
their commitments.
18. *In carrying out open market operations, the Federal Reserve usually buys and
Could the Federal Reserve continue to carry out open market operations? (LO2)
Answer: In theory, yes. In the absence of Treasury securities, the Federal Reserve
imposing market distortions when conducting open market operations.
19. In which of the following cases will the size of the central bank’s balance sheet
change? (LO2)
a. The Federal Reserve conducts an open market purchase of $100 million
million due to withdrawals by the public.
Answer: The size of the central bank’s balance sheet will rise in cases (a) and (b).
On the liability side in both these cases, reserves rise by $100 million. On the
reserves to currency, but the overall size of the balance sheet remains unchanged.
20. *You read a story reporting a major scandal about the Federal Deposit Insurance
relationship between the monetary base and the money supply? (LO4)
Answer: The scandal is likely to increase the public’s desire to hold currency as
the safety of their deposits comes into question; the currency-to-deposit ratio is
multiplier, thus reducing the stock of money for a given monetary base.
21.Use your knowledge of the money multiplier to explain why the massive increase
in bank reserves that began in the 2007-2009 financial crisis has not resulted in
uncontrolled inflation. (LO3)
Answer: While the increase in reserves expanded the monetary base, this did not
banks’ demand for excess reserves; and (2) the payment of interest on excess
holding reserves has supported banks’ demand for them, so the multiplier has
remained low.
22.Explain the distinction between the “zero lower bound” and the “effective lower
supply of bank credit? (LO3, LO4)
Answer: If there were no transactions costs associated with using cash, its zero
rate of return would impose a zero lower bound on nominal interest rates.
zero lower bound minus those costs.
If nominal rates were pushed below the effective lower bound, we would expect
lower bound would be contractionary because it would diminish the supply of bank
credit.
Data Exploration
1. Plot on a weekly basis the ratio of currency (FRED code: CURRENCY) to
checkable deposits (FRED code: TCD) from the start of 2000 through 2002 and
the numerator or the deposits term in the denominator? Explain your reasoning.
(LO2)
Answer: In the plot below, the downward spike occurred during the week of
September 11.Examining the downloaded data, you will see it is due to a sharp,
been credited to accounts of check recipients were debited to the accounts on
which they were drawn only after air travel resumed.
2. Figure 17.10 shows a sharp decline of the M1 money multiplier in 2008. What
caused the drop? Using the indicators for currency (FRED code: CURRSL), total
(Hint: To estimate excess reserves, see footnote 8. Divide RESBALREQ by 1,000
to convert the units to billions of dollars.) (LO3)
Answer: Prior to the financial crisis, excess reserve holdings as a percentage of
demands. While the currency-to-deposit ratio was gradually falling, it cannot
account for the abrupt change in the multiplier.
3. In the Great Depression, the Fed allowed the money supply to decline. To confirm
that the Federal Reserve learned from this lesson, plot since 2000 the M2
conducting policy in order to sustain the expansion of M2. (LO4)
Answer: The plot is below. M2 is the product of the M2 multiplier and the
monetary base, M2 = m*MB. M2 can rise if a decline in the value of the
support the continued rise of M2 (unlike the Great Depression).
4. Prior to the financial crisis of 2007-2009, the Fed seldom reduced its holdings of
basis. Did the Fed’s practices change during the crisis? If so, how? (Hint:
Examine Table 17.1 to help with your response.) (LO2)
Answer: The data plot is below. In 2008, the Fed allowed its short-term Treasury
securities to mature without replacement in order to offset the impact on its asset
failure, the Fed initiated the first round of quantitative easing (QE1), sharply
expanding the size of its asset holdings.
5. Thousands of the data series on FRED are provided directly by the Board of
How does this balance sheet transparency affect the conduct of monetary policy?
(LO1)
Answer: Public disclosure of information about the balance sheet is crucial for the
credibility of a central bank. The Fed’s detailed, high-frequency disclosures add
testimony, and speeches). Consistency of words and deeds is essential for
credibility.
* indicates more difficult problems
