Economics Chapter 14 Interactive Activity Money Banking And The Federal Reserve System For Each

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S-195

interactive activity

Chapter 14

Money, Banking, and

the Federal Reserve System

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

b. 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

c. Moving money from savings to checking has no effect on M2, since both

d. Depositing cash into a checking account does not change M1 or M2. You are

e. Depositing $0.25 into your savings account has no effect on M2, since both

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?

Solution

3. The following table shows the components of M1 and M2 in billions of dollars

for the month of December in the years 2006 to 2016 reported by the Federal

Reserve Bank of St. Louis. Complete the table by calculating M1, M2, currency

in circulation as a percentage of M1, and currency in circulation as a percent-

age of M2. What trends or patterns about M1, M2, currency in circulation as a

percentage of M1, and currency in circulation as a percentage of M2 do you see?

What might account for these trends?

Year

Currency in

circulation

Traveler’s

checks

Checkable

deposits

Savings

deposits

Time

deposits

Money

market

funds M1 M2

Currency in

circulation

as a

percentage

of M1

Currency in

circulation

as a

percentage

of M2

2006 $750.2 $6.7 $ 611.3 $3,694.9 $1,206.1 $772.2 ? ? ? ?

2007 760.6 6.3 609.5 3,898.4 1,276.1 923.3 ? ? ? ?

2008 816.3 5.5 785.1 4,089.4 1,457.9 1,012.5 ? ? ? ?

2009 863.7 5.1 829.7 4,813.1 1,188.3 771.1 ? ? ? ?

2010 918.8 4.7 919.0 5,331.3 933.2 668.1 ? ? ? ?

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 2006 to 2016, M1 more than doubled.

M2 almost doubled from 2006 to 2016. Currency as a percentage of M1 was 55%

prior to the Great Recession, but fell below 44% by 2013 where it has remained.

Currency as a percentage of M2 was almost constant at between 10% and 11%.

Year

Currency in

circulation

Traveler’s

checks

Checkable

deposits

Savings

deposits

Time

deposits

Money

market

funds M1 M2

Currency in

circulation

as a

percentage

of M1

Currency in

circulation

as a

percentage

of M2

2006 $750.2 $6.7 $ 611.3 $3,694.9 $1,206.1 $772.2 $1,368.2 $7,041.4 54.8% 10.7%

2007 760.6 6.3 609.5 3,898.4 1,276.1 923.3 1,376.4 7,444.2 55.3 10.2

2008 816.3 5.5 785.1 4,089.4 1,457.9 1,012.5 1,606.90 8,166.7 50.8 10.0

2009 863.7 5.1 829.7 4,813.1 1,188.3 771.1 1,698.5 8,471.0 50.9 10.2

2010 918.8 4.7 919.0 5,331.3 933.2 668.1 1,842.5 8,775.1 49.9 10.5

Data from: Federal Reserve Bank of St. Louis.

Solution

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

a. $95 on your campus meal card

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. The reserve ratio is 10%.

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

does it change the money supply?

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

deposit?

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?

Solution

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 with–

drawal? Assume that the bank responds to insufficient reserves by reducing

the amount of deposits it holds until its level of reserves satisfies its required

reserve ratio. The bank reduces its deposits by calling in some of its loans,

forcing borrowers to pay back these loans by taking cash from their checking

deposits (at the same bank) to make repayment.

c. If every time the bank decreases its loans, checkable bank deposits fall by

the amount of the loan, by how much will the money supply in the economy

contract in response to Ryan’s withdrawal of $400?

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 –$400 Checkable deposits –$400

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

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

required reserves for the $400 deposit; however, the remaining $360 was being

c. The money supply will contract by ($400/0.1) – $400 = $3,600. Checkable

deposits fall by $4,000, but only $3,600 represents a decrease in the money

supply because $400 of the $4,000 fall in checkable deposits has been con-

verted into cash in Ryan’s wallet.

d. The money supply will decrease by ($400/0.2) – $400 = $1,600. Checkable

deposits fall by $2,000, but only $1,600 represents a decrease in the money

supply.

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

a. What is M1?

b. What is the monetary base?

Solution

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

deposits ($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) and bank deposits at the central bank ($200 million)]. The

monetary base is $450 million.

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 accompa-

nying table. (Hint: The first row shows that the bank must hold $100 in mini-

mum reserves—20% of the $500 deposit—against this deposit, leaving $400 in

Round Deposits

Required

reserves

Excess

reserves Loans

Held as

currency

1$500.00 $100.00 $400.00 $400.00 $200.00

2200.00 ? ? ? ?

3 ? ? ? ? ?

4 ? ? ? ? ?

5 ? ? ? ? ?

6 ? ? ? ? ?

7 ? ? ? ? ?

8 ? ? ? ? ?

9 ? ? ? ? ?

10 ? ? ? ? ?

Solution

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

Round Deposits

Required

reserves

Excess

reserves Loans

Held as

currency

1$500.00 $100.00 $400.00 $400.00 $200.00

380.00 16.00 64.00 64.00 32.00

512.80 2.56 10.24 10.24 5.12

72.05 0.41 1.64 1.64 0.82

90.33 0.07 0.26 0.26 0.13

10 0.13 0.03 0.10 0.10 0.05

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

checkable-deposits-only system?

9. a. Checkable deposits contract by $700/0.25 = $2,800, but $700 is converted into cur–

rency held by the public. The money supply contracts by $2,800 – $700 = $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; the initial required reserve ratio is 10%. The commercial banks follow

a policy of holding no excess reserves. The public holds no currency, only check-

able deposits in the banking system.

Solution

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

b. If the required reserve ratio rises to 25%, the commercial banks of Albernia

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

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

banks when the Federal Reserve sells $30 million in U.S. Treasury bills. If the

public holds a fixed amount of currency (so that all new loans create an equal

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

Initial changes to the T-account of the Federal Reserve immediately after the

Fed sale of $30 million in Treasury bills:

Assets Liabilities

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

sale of $30 million in Treasury bills:

Assets Liabilities

Reserves –$30 million

Solution

S-202 Chapter 14 Money, Banking, and the Federal reserve systeM

After the Federal Reserve sells $30 million in Treasury bills, the banks are no

All changes to the T-account of commercial banks after the Fed sale of

$30 million in Treasury bills:

Assets Liabilities

Reserves –$30 million

Loans –$600 million

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

b. The amount of interest forgone per year is 0.87% × $45 million = $391,500.

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. On

the top of page, under “Data” and “Money Stock and Reserve Balances,” select

the link “Factors Affecting Reserve Balances – H.4.1.” Click on the link for the

current release.

14. a. Answers will vary. As of data released on June 1, 2017, the Fed had $4,420,982

Solution

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

per month, between January 1980 and December 2016. 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

500

New housing

starts

(thousands)

Year

1980

Data from: Federal Reserve Bank of St. Louis.

2016

2010

2005

2000

1985

1995

1990

a. What caused the drop in new housing starts in 1984–1991?

b. What caused the drop in new housing starts in 2006–2009?

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

b. The drop in new housing starts in 2006–2009 was caused by the unavailability

of easy mortgage financing that precipitated the 2008 financial crisis. When

c. Better regulation of the S&Ls could have prevented them from investing in

Solution

S-204 Chapter 14 Money, Banking, and the Federal reserve systeM

Solution

WORK IT OUT Interactive step-by-step help with solving this

problem can be found online.

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

mercial banks when the Federal Reserve buys $50 million in U.S. Treasury

bills. If the public holds a fixed amount of currency (so that all loans create

an equal amount of deposits in the banking system), the minimum reserve

ratio is 10%, and banks hold no excess reserves, by how much will depos–

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 liabilities also increase by $50 million as it credits the banks’

accounts at the Federal Reserve, part of the monetary base. From the perspec-

Initial changes to the T-account of the Federal Reserve immediately after the

Fed purchase of $50 million in Treasury bills:

Assets Liabilities

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

purchase of $50 million in Treasury bills:

Assets Liabilities

Reserves +$50 million

After the Federal Reserve buys $50 million from commercial banks, the banks

are holding $50 million in excess reserves. Since the banks do not want to hold

Total changes to the T–account of commercial banks after the Fed purchase of

$50 million in Treasury bills:

Assets Liabilities

Reserves +$50 million

Loans +$500 million