Deck 14: The Money Supply Process

Question 1

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.
"The money multiplier is necessarily greater than 1." Is this statement true, false, or uncertain? Explain your answer.

Answer 1

It is given that the required reserve ratio is 10% and that banks do not hold any excess reserves. It is required to be answered whether the statement: "the money multiplier is necessarily greater than 1" is true, false, or certain.
The formula for multiplier is as follows: It is given that banks do not hold any excess reserves, which means that the reserve-deposit ratio will equal required-reserve ratio. Therefore, reserve-deposit ratio is 10% (i.e. 0.10).
The reserve-deposit ratio is 0.10, which is less that one. From this, the following can be deduced. Therefore, the given statement is true.

Question 2

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

Answer 2

When there is a financial panic, the amount of deposits ( D ) decreases due to people's lack of confidence in the financial system and their decision to withdraw their funds from banks. Recall that the currency ratio ( c ) and excess reserves ratio ( e ) are calculated as follows: A decrease in D would increase both c and e.
The money multiplier ( m ) indicates how much the money supply changes for a given change in the monetary base. It is calculated as: When e and c increase, m decreases because the denominator increases more than the numerator. Therefore, .
A financial panic can cause a substantial . Depositors shift their holdings from checkable deposits to currency by withdrawing currency from their bank accounts. The money supply model predicts that when e and c increase, the money supply will contract because the rise in c results in a decline in the overall level of multiple deposit expansion. This leads to a smaller money multiplier and a decline in the money supply.
The rise in e reduces the amount of reserves available to support deposits, which also causes money supply to decrease.

Question 3

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.
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?

Answer 3

The Great Depression years, 1930-1933, and currency ratio:
The 1930s were a period of great economic uncertainty, during which there were many bank failures, wherein banks were unable to meet the demands of their depositors for cash. Further, because there was no deposit insurance at that time, so when a bank failed, depositors would only receive partial repayment of their deposits.
[The first bank panic came around October 1930 to January 1931, during which, among others, there were 256 banks failures involving $180 million of deposits in November 1930, 532 failures involving $370 million of deposits in December and the most dramatic being the failure of the Bank of United States with over $200 million in deposits on 11 th December 1930.]
Therefore, when banks were failing during bank panics, depositors knew that they would be likely to suffer substantial losses on deposits and thus the expected return on deposits would be negative. The theory of asset demand predicts that with the onset of the bank crisis, depositors would shift their holdings from checkable deposits to currency by withdrawing currency from their bank accounts. This prediction was borne out in reality and consequently, the currency ratio, c , rose.
The Impact of the Rise of Currency Ratio on the Money Supply:
Banking crises continued to occur from 1931 to 1933: Money stock fell rapidly in 1931 and 1932 and continued through April 1933. At the same time, the composition of the money stock changed. In March 1931, the currency ratio wAS₁8.5%; two years later it was 40.7%.
By the end of the crises, the money supply had declined over 25% - by far the largest decline in the entire American history. Even more remarkable is that this decline continued despite a 20% rise in the monetary base - which illustrates how important the changes in the currency ratio can be in the determination of money supply.
Why did money supply decrease due to a rise in the currency ratio
The fall in the money supply was in part the result of large-scale bank failures. Banks failed because they did not have the reserves with which to meet the customers' cash withdrawals, and in failing they destroyed deposits and hence reduced the money supply.
But the failures went further in reducing the money supply, because they led to a loss of confidence on the part of the depositors and hence to an even higher currency ratio. The rise in the currency ratio (and also the excess reserves ratio) reduced the money multiplier and hence sharply contracted the money supply.
The relation between money supply ( M ), the money multiplier and the monetary base ( MB ) is given by: ...... (1)
Where,
m : money multiplier = ......(2)
c : currency ratio = r : reserve ratio = e : excess reserves ratio = M , Money Supply = MB , Monetary Base = ER : Excess reserves held by the banks.
D : Total checkable deposits
C : Currency in circulation
Keeping everything else constant, money supply, M , is negatively related to currency holdings and hence the currency reserve ratio. This is because, when c increases, more checkable deposits are converted into currency holdings and there is a switch from a component of money supply that undergoes multiple expansions to one that does not. Thus, the overall level of multiple expansion declines and the money supply falls.

Question 4

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.
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.

Question 5

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.
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?

Question 6

Go to http://www.federalreserve.gov/boarddocs/hh/ and find the most recent annual report of the Federal Reserve. Read the first section of the annual report, which summarizes Monetary Policy and the Economic Outlook. Write a one-page summary of this section of the report.

Question 7

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.
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?

Question 8

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.
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?

Question 9

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.
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.

Question 10

Go to http://www.federalreserve.gov/releases/h6/hist/ and find the historical report of M1 and M2. Compute the growth rate of each aggregate over each of the past three years (it will be easier to do this if you move the data into Excel, as demonstrated in Chapter 1). Does it appear that the Fed has been increasing or decreasing the rate of growth of the money supply? Is this consistent with your understanding of the needs of the economy? Why?

Question 11

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.
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.

Question 12

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.
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?

Question 13

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.
If the Fed lends five banks a total of $100 million but depositors withdraw $50 million and hold it as currency, what happens to reserves and the monetary base? Use T-accounts to explain your answer.

Question 14

An important aspect of the supply of money is reserve balances. Go to http://www.federalreserve.gov/Releases/h41/ and locate the most recent release. This site reports changes in factors that affect depository reserve balances.
a. What is the current reserve balance?
b. What is the change in reserve balances since a year ago?
c. Based on your results in parts (a) and (b), does it appear that the money supply should be increasing or decreasing?

Question 15

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.
Using T-accounts, show what happens to checkable deposits in the banking system when the Fed lends $1 million to the First National Bank.

Question 16

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.
If a bank depositor withdraws $1,000 of currency from an account, what happens to reserves, checkable deposits, and the monetary base?

Question 17

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.
Using T-accounts, show what happens to checkable deposits in the banking system when the Fed sells $2 million of bonds to the First National Bank.

Question 18

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.
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?

Question 19

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.
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?

Question 20

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.
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?

Question 21

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.
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.

Question 22

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.
"The Fed can perfectly control the amount of reserves in the system." Is this statement true, false, or uncertain? Explain.

Question 23

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.
If the Fed reduces reserves by selling $5 million worth of bonds to the banks, what will the T-account of the banking system look like when the banking system is in equilibrium? What will have happened to the level of checkable deposits?

Question 24

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.
"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.

Question 25

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.
If the Fed sells $1 million of bonds and banks reduce their borrowings from the Fed by $1 million, predict what will happen to the money supply.

Question 26

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.
The Fed buys $100 million of bonds from the public and also lowers the required reseme ratio. What will happen to the money supply?

Question 27

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.
Suppose that currency in circulation is $600 billion, the amount of checkable deposits is $900 billion, and excess reserves are $15 billion.
a. Calculate the money supply, the cun'ency deposit ratio, the excess reserve ratio, and the money multiplier.
b. Suppose the central bank conducts an unusually large open market purchase of bonds held by banks of $1400 billion due to a sharp contraction in the economy. Assuming the ratios you calculated in part (a) remain the same, predict the effect on the money supply.
c. Suppose the central bank conducts the same open market purchase as in part (b), except that banks choose to hold all of these proceeds as excess reserves rather than loan them out, due to fear of a financial crisis. Assuming that currency and deposits remain the same, what happens to the amount of excess reserves, the excess reserve ratio, the money supply, and the money multiplier?
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)?

Question 28

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.
Describe how each of the following can affect the money supply:
(a) the central bank;
(b) banks; and
(c) depositors.