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CORNELL ECON 102 - Problem Set #6

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Economics 102 Professor McClellandFall 2007Problem Set # 6DUE MONDAY, OCT. 22, IN WHICHEVER ROOM YOU ARETAKING THE EXAM.Problem sets are to be turned in AT THE END OF THE EXAM.Place your problem set answers, as well as your exam answers, in the box with your TA’s name and section on it.NO CREDIT WILL BE GIVEN FOR LATE PROBLEM SETS.This exercise is on the multiple contraction of the money supply resulting from open market salesof securities by the Federal Reserve. Assume:(a) the reserve requirement of commercial banks is 10%, and(b) all commercial banks hold NO excess reserves.I. Suppose the Federal Reserve sells two $14,000 bonds, one each to Irene and Paul. Irene paysfor her bond with money she withdraws from her account at Nations Bank. Paul pays for his bond with money he stored in his closet.a. The following is Nations Bank's balance sheet before Irene withdraws $14,000 in cash. Complete the balance sheet.Nations Bank: Balance SheetAsset LiabilitiesReserves Demand Deposits:Loans of Irene19,000Securities25,000of othersTotal220,000Totalb. Show the impact of Irene's withdrawal of cash on Nations Bank's balance sheet.Nations Bank: Balance SheetAsset LiabilitiesReserves Demand Deposits:Loans of IreneSecurities of othersTotal Totalc. By how much do Nations Bank's reserves fall short of the legal requirement?OVEREconomics 102 Professor McClellandII. Suppose Nations Bank replenishes its reserves by selling some of its securities to Sarah (i.e. the bank sells Sarah securities equal to the amount its reserves fall short). Sarah has a checking account at the Bank of America.a. Complete the Bank of America's balance sheet before Sarah purchases the securities.The Bank of America: Balance SheetAsset LiabilitiesReserves Demand Deposits:Loans120,000of Sarah34,000Securities of others526,000Total Totalb. Show what happens on Nations Bank's and the Bank of America's balance sheets when Sarah pays for those securities by giving Nations Bank a personal check on her deposit at the Bank of America, which Nations Bank turns over to the Bank of America in exchangefor cash.Nations Bank: Balance SheetAsset LiabilitiesReserves Demand Deposits:Loans of IreneSecurities of othersTotal TotalThe Bank of America: Balance SheetAsset LiabilitiesReserves Demand Deposits:Loans of SarahSecurities of othersTotal TotalIII. What is the decrease in money supply so far, due only to the original sale of two bonds to Irene and to Paul as well as the subsequent sale of Nations Bank's securities to Sarah?IV. a. If the Bank of America replenishes its shortage of reserves (caused by transactions described in II) by selling some of its securities, how much must it sell?b. What will be the ultimate decrease in the money supply resulting from this initial sale of two bonds by the Federal Reserve?c. How is your answer to IV (b) changed if Nations Bank begins with $14,000 of excess


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