Chapter 14 You sell a few shares of stock and put the proceeds

Solution

1. For each of the following transactions, what is the initial effect (increase or decrease)

on M1? On M2?

1. a. Shares of stock are not a component of either M1 or M2, so holding fewer shares

does not decrease either M1 or M2. However, depositing the money into your sav-

ings account increases M2, since savings accounts are part of M2 (but not part of

M1). M1 does not change.

b. Shares of stock are not a component of either M1 or M2, and so holding fewer

shares does not decrease either M1 or M2. However, depositing the money into

your checking account increases M1, since checking accounts are part of M1. It

2. There are three types of money: commodity money, commodity-backed money, and

fiat money. Which type of money is used in each of the following situations?

14

CHAPTER

Money, Banking, and the

Federal Reserve System

Solution

S-196 CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM

2. a. A bottle of rum is commodity money since the rum has other uses.

b. Salt is commodity money since it has other uses.

3. In the completed table that follows, M1 consists of currency in circulation, trav-

eler’s checks, and checkable deposits. M2 consists of M1 plus money market funds,

time deposits, and savings deposits. From 2003 to 2013, M1 more than doubled. M2

almost doubled from 2003 to 2013. Currency as a percentage of M1 was relatively

stable, at around 50%, with a rise during the economic boom years until 2007 and

Currency Currency

in in

circulation circulation

Currency Money as a as a

in Traveler’s Checkable Savings Time market percentage percentage

Year circulation checks deposits deposits deposits funds M1 M2 of M1 of M2

2003 $662.5 $7.6 $635.9 $3,159.0 $818.1 $752.8 ? ? ? ?

2004 697.8 7.5 670.6 3,506.5 828.4 677.6 ? ? ? ?

2005 724.6 7.2 643.0 3,601.6 993.7 682.4 ? ? ? ?

2006 750.2 6.7 610.6 3,691.8 1,206.0 776.6 ? ? ? ?

Solution

4. Indicate whether each of the following is part of M1, M2, or neither:

a. $95 on your campus meal card

b. $0.55 in the change cup of your car

4. a. $95 on your campus meal card is similar to a gift certificate. Because it can only be

used for one purpose, it is not part of either M1 or M2.

b. $0.55 in the change cup of your car is part of currency in circulation; it is part of

both M1 and M2.

5. Tracy Williams deposits $500 that was in her sock drawer into a checking account at

the local bank.

a. How does the deposit initially change the T-account of the local bank? How does it

change the money supply?

CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-197

Currency Currency

in in

circulation circulation

Currency Money as a as a

in Traveler’s Checkable Savings Time market percentage percentage

Year circulation checks deposits deposits deposits funds M1 M2 of M1 of M2

2003 $662.5 $7.6 $635.9 $3,159.0 $818.1 $752.8 $1,306.0 $6,035.9 51% 11%

2004 697.8 7.5 670.6 3,506.5 828.4 677.6 1,375.9 6,388.4 51% 11%

2005 724.6 7.2 643.0 3,601.6 993.7 682.4 1,374.8 6,652.5 53% 11%

Solution

c. If every time the bank makes a loan, the loan results in a new checkable bank

deposit in a different bank equal to the amount of the loan, by how much could

the total money supply in the economy expand in response to Tracy’s initial cash

deposit of $500?

5. a. Initially, the bank’s reserves rise by $500, as do its checkable deposits. There is no

initial change in the money supply; currency in circulation has fallen by $500 but

checkable deposits have increased by $500.

6. Ryan Cozzens withdraws $400 from his checking account at the local bank and keeps

it in his wallet.

a. How will the withdrawal change the T-account of the local bank and the money

supply?

b. If the bank maintains a reserve ratio of 10%, how will it respond to the withdrawal?

Assume that the bank responds to insufficient reserves by reducing the amount

6. a. Initially, the bank’s reserves fall by $400, as do its checkable deposits. There is no

initial change in the money supply; currency in circulation has risen by $400 but

checkable deposits have decreased by $400.

Assets Liabilities

Reserves +$500 Checkable deposits +$500

S-198 CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM

Solution

b. Assuming that the bank has other checkable deposits, the bank will be holding

insufficient reserves. The bank was holding $40 of the $400 withdrawal as required

7. The government of Eastlandia uses measures of monetary aggregates similar to those

used by the United States, and the central bank of Eastlandia imposes a required

reserve ratio of 10%. Given the following information, answer the questions below.

Bank deposits at the central bank = $200 million

Currency held by public = $150 million

7. a. M1 equals the sum of currency held by the public ($150 million), checkable depos-

its ($500 million), and traveler’s checks ($10 million), or $660 million.

b. The monetary base is the sum of currency held by the public ($150 million) and

the reserves of the commercial banks [currency in bank vaults ($100 million)

CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-199

KrugWellsECPS4e_Macro_CH14.indd S-199KrugWellsECPS4e_Macro_CH14.indd S-199 2/9/15 10:00 AM2/9/15 10:00 AM

Solution

8. In Westlandia, the public holds 50% of M1 in the form of currency, and the required

reserve ratio is 20%. Estimate how much the money supply will increase in response

to a new cash deposit of $500 by completing the accompanying table. (Hint: The first

row shows that the bank must hold $100 in minimum reserves—20% of the $500

8. As shown in the accompanying table, after 10 rounds, loans can expand by $666.60;

this is also the increase in the money supply at this point. (Although deposits increase

by $833.25, currency held by the public falls by $166.70—it initially fell by $500 and

eventually rose again by $333.30.) If the total amount of each loan is deposited in the

banking system (that is, the public does not hold any of the loans in currency), the

money supply would increase by ($500/0.2) − $500 = $2,000; deposits would increase

by $2,500. The money multiplier decreases in size as the public holds a greater per-

centage of loans in currency.

Required Excess Held as

Round Deposits reserves reserves Loans currency

1 $500.00 $100.00 $400.00 $400.00 $200.00

2 200.00 40.00 160.00 160.00 80.00

Required Excess Held as

Round Deposits reserves reserves Loans currency

1 $500.00 $100.00 $400.00 $400.00 $200.00

2 200.00 ? ? ? ?

3 ? ? ? ? ?

4 ? ? ? ? ?

10 rounds ? ? ? ? ?

S-200 CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM

KrugWellsECPS4e_Macro_CH14.indd S-200KrugWellsECPS4e_Macro_CH14.indd S-200 2/9/15 10:00 AM2/9/15 10:00 AM

Solution

9. What will happen to the money supply under the following circumstances in a

checkable-deposits-only system?

a. The required reserve ratio is 25%, and a depositor withdraws $700 from his check-

able bank deposit.

9. a. Checkable deposits contract by $2,800, but $700 is converted into currency held by

the public. The money supply contracts by $2,100.

10. Although the U.S. Federal Reserve doesn’t use changes in reserve requirements to

manage the money supply, the central bank of Albernia does. The commercial banks

of Albernia have $100 million in reserves and $1,000 million in checkable deposits;

10. a. If the required reserve ratio falls to 5%, the commercial banks of Albernia will be

holding $50 million in excess reserves. Since the banks follow a policy of holding

no excess reserves, the banks will expand deposits by making loans. The banks’

11. Using Figure 14-6, find the Federal Reserve district in which you live. Go to

CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-201

KrugWellsECPS4e_Macro_CH14.indd S-201KrugWellsECPS4e_Macro_CH14.indd S-201 2/9/15 10:00 AM2/9/15 10:00 AM

Solution

11. Answers will vary depending on where you live and when you look up your answer. For

12. Show the changes to the T-accounts for the Federal Reserve and for commercial banks

12. When the Federal Reserve sells $30 million in Treasury bills to commercial banks, its

assets decrease by $30 million (it now owns $30 million less in Treasury bills), but

its liabilities also decrease by $30 million as the banks pay the Federal Reserve for the

Treasury bills from their accounts at the Fed (part of the monetary base). From the

perspective of commercial banks, their assets rise by $30 million because they buy the

S-202 CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM

Solution

13. The Congressional Research Service estimates that at least $45 million of counterfeit

U.S. $100 notes produced by the North Korean government are in circulation.

a. Why do U.S. taxpayers lose because of North Korea’s counterfeiting?

13. a. When North Korea circulates fake currency, the Federal Reserve does not hold any

assets, and the U.S. government does not get the interest from the Treasury bills

14. As shown in Figure 14-9, the portion of the Federal Reserve’s assets made up of U.S.

Treasury bills has declined since 2007. Go to www.federalreserve.gov. Under “Select

Statistical Releases,” click on “View All.” Under the heading “Money Stock and

Reserve Balances,” click on “Factors Affecting Reserve Balances.” Click on the date of

the current release.

a. Under “Statement of Condition of Federal Reserve Bank,” look in the “Total” col-

14. a. Answers will vary. As of data released on November 28, 2014, the Fed’s assets

CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-203

KrugWellsECPS4e_Macro_CH14.indd S-203KrugWellsECPS4e_Macro_CH14.indd S-203 2/9/15 10:00 AM2/9/15 10:00 AM

Solution

15. The accompanying figure shows new U.S. housing starts, in thousands of units per

month, between January 1980 and January 2014. The graph shows a large drop in

new housing starts in 1984–1991 and 2006–2009. New housing starts are related to

the availability of mortgages.

2,500

New housing

starts

(thousands)

15. a. The drop in new housing starts in 1984–1991 was caused by the unavailability of

easy mortgage financing resulting from the Savings and Loans (S&L) crisis. S&Ls

had invested in overly risky real estate assets, and many of them failed. As the gov-

ernment closed over 1,000 S&Ls, mortgages became less easily available, and new

housing starts dropped dramatically.

S-204 CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM

KrugWellsECPS4e_Macro_CH14.indd S-204KrugWellsECPS4e_Macro_CH14.indd S-204 2/9/15 10:00 AM2/9/15 10:00 AM

Solution

16. Show the changes to the T-accounts for the Federal Reserve and for commercial banks

16. When the Federal Reserve buys $50 million in Treasury bills from commercial banks, its

assets increase by $50 million (it now owns $50 million in Treasury bills) but its liabili-

ties also increase by $50 million as it credits the banks’ accounts at the Federal Reserve,

Assets Liabilities

Treasury bills +$50 million Monetary base +$50 million

Initial changes to the T-account of commercial banks immediately after the Fed pur–

chase of $50 million in Treasury bills:

CHAPTER 14 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-205

KrugWellsECPS4e_Macro_CH14.indd S-205 2/9/15 10:00 AM