Practice Set For Money Supply Process - Classify Each Of The

Practice Set For Money Supply Process1 Classify Each Of These Transac

PRACTICE SET FOR MONEY SUPPLY PROCESS 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. Public: Assets Liabilities Banks: Assets Liabilities

b. You deposit $400 into your checking account at the local bank. Public: Assets Liabilities Banks: Assets Liabilities Fed: Assets Liabilities

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

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

2. 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?

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

4. 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?

5. 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?

6. “The Fed can perfectly control the amount of borrowed reserves in the banking system” — Is this statement true, false, or uncertain?

7. If credit risk in the banking system increases, all else equal, what effect, if any, will this have on the money multiplier?

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

9. 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?

10. 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.

11. If the Fed sells $2 million of bonds to Irving the Investor, who pays for the bonds with currency, what happens to reserves and the monetary base? Use T-accounts to explain.

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

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

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

15. Suppose currency in circulation is $600 billion, checkable deposits are $900 billion, and excess reserves are $15 billion. Calculate the money supply, currency deposit ratio, excess reserve ratio, and the money multiplier. Then predict the effect of a large open market purchase of bonds of $1400 billion on the money supply, assuming ratios remain the same. Finally, analyze what happens if banks hold all proceeds as excess reserves, and relate this to historical scenarios like the 2008 financial crisis.

Paper For Above instruction

The money supply process is fundamental to understanding macroeconomic stability and the effectiveness of monetary policy. It involves multiple actors—namely, the Federal Reserve (Fed), commercial banks, and the public (depositors). The interactions among these players through various transactions dictate changes in the money supply, which influences inflation, interest rates, and economic growth. Through a detailed classification of transactions, conceptual understanding of reserves, checkable deposits, and the monetary base, and an analysis of recent macroeconomic events, we can appreciate the intricate mechanisms that govern the economy's liquidity.

Classifying Transactions in the Money Supply Process

Understanding how each transaction affects the balance sheets of the participants is crucial. When an individual receives a loan from a bank, the borrower’s asset (cash or automobile) increases, and the bank’s assets increase with the loan amount. Conversely, deposit transactions, such as depositing $400 into a checking account, increase the bank's assets via reserves and liabilities via checkable deposits, while the depositor’s assets decrease traditional cash holdings. The Fed's emergency loans to banks and open market operations, such as bond purchases, directly influence bank reserves and the monetary base.

Impact of Open Market Operations and Reserve Changes

If the Fed purchases bonds from banks, like a $1 million buy, reserves increase, boosting banks’ capacity to create loans and deposits, thereby expanding the money supply if loans are extended. Conversely, bond sales reduce reserves and the monetary base, contracting the money supply. When depositors withdraw cash, reserves decline, checkable deposits decrease, and the monetary base reduces accordingly. Selling bonds to an investor who pays with currency similarly reduces reserves and the monetary base, demonstrating the transmission mechanism through which open market operations influence liquidity.

Bank Lending, Reserve Requirements, and Multiplier Effects

The process of bank lending and reserve holdings dramatically affect the money multiplier—the ratio of checkable deposits to the reserves—which amplifies initial monetary base changes into larger changes in the overall money supply. An increase in credit risk or a financial panic typically constrains bank lending, reducing the money multiplier and slowing the growth of the money supply. Payment of interest on excess reserves by the Fed alters banks' incentives, potentially decreasing the lending activity and thus the multiplier effect, especially during crises.

Applied Analysis and Historical Context

Using T-accounts, we can trace the effects of specific operations such as bond sales, bond purchases, and lending on reserves and checkable deposits. For example, a $2 million bond sale to the Fed causes reserves to decrease, shrinking the monetary base, with subsequent effects on the money supply depending on the reserve ratio. Similar logic applies when banks repay loans or when they choose to hold excess reserves instead of loaning out funds.

Furthermore, calculations of the money supply, currency deposit ratios, and excess reserves ratios provide quantitative insights into the economy’s liquidity. The 2008 financial crisis exemplified how large reserves held as excess reserves, coupled with reduced lending, can cause the money multiplier to fall below unity, implying minimal growth or contraction of the money supply despite expansive monetary policy measures.

Conclusion

In sum, the money supply process is a complex interplay of banking operations, central bank actions, and public behavior. Recognizing how specific transactions influence reserves, deposits, and the monetary base—and how these effects are amplified or dampened by the banking system’s behavior—is essential for policymakers and economists. This understanding enables better prediction of macroeconomic outcomes and the design of effective monetary policies to promote economic stability and growth.

References

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