Economics 102Spring 2004Answers to Practice Homework 7 .Concepts: Definition and calculation of the money supplyA bank’s balance sheetThe Federal Reserve systemThe money multiplierThe relationship between the money market and the bond marketMultiple Choice Questions:1. Which of the following is NOT a function of money?(a) It facilitates the barter system.(b) It serves as a store of wealth.(c) It serves as a unit of value.(d) It serves as a medium of exchange.ANS: (a) - barter is the transaction system used before the introduction of money.2. The Required Reserve Ratio (RR) is a percentage set by the Federal Reserve Systemthat requires banks to: (a) Lend the RR percent of the bank’s customer Demand Deposits (DD) to the public.(b) Hold the RR percent of the bank’s customer DD in the form of cash in their vault orin accounts at the Federal Reserve.(c) Pay RR percent of the bank’s customer DD to the Federal Reserve as an annualmembership fee.(d) Hold the RRR percent of the bank’s customer DD in the forms of cash in their vault.ANS: (b) - The bank always has an account with the Fed that facilitates its dailyoperations. Moreover the funds that the bank holds as their required reserves is theportion of money that the bank CANNOT lend out to its customers.3. An open market operation (OMO) refers to:(a) The purchase of goods and services by the Fed.(b) An announcement about the level of the money supply in the economy.(c) The process of printing more money and distributing it to the public.(d) The purchase or sale of bonds to influence the level of the money supply in theeconomy.ANS: (d) by definition.4. Which of the following actions by the government is most likely to increase themoney supply in an economy? (Hint: it is probably better to first answer Q3 of theproblems)(a) Decreasing the RRR while selling bonds in the market.(b) Increasing the RRR while selling bonds in the market.(c) Buying bonds in the market.(d) None of the above would have any effect on the money supply.ANS: (c) by observations from Q3 in the problems.5. Money Demand, when plotted against the interest rate, is downward sloping because:(a) At higher interest rates the opportunity cost of holding money is lower.(b) Banks typically want more savings when the interest rate is higher.(c) At higher interest rates the opportunity cost of holding money is higher.(d) Individuals dislike putting money in the bank.ANS: (c) since ‘money’ is defined to be cash in public hands + DD – those funds liquidenough for transaction purposes, which earns no interests. 6. Which of the following events does not shift the money demand curve?(a) An increase in the interest rate.(b) Citizens expect bank runs on major banks.(c) The real income of the economy increases.(d) The price level increases.ANS: (a) – if the interest rate changes, then we have a movement along the moneydemand curve.Problems:1. Suppose the country of Econometallica has the following monetary asset informationas of April 2004:Cash in hands of the public = $300b (where ‘b’ represents billion)Demand Deposits (DD) = $400bOther Checkable Deposits = $150bTraveler’s checks = $50bSavings Type accounts = $2000bMoney Market Mutual Funds (MMMF) = $1000bSmall Time Deposits = $500bLarge Time Deposits = $450b(a) Calculate M1 for Econometallica.ANS: M1 = Cash in hands of public + Demand Deposits + Other Checkable Deposits +Traveller’s Check = 300b + 400b + 150b + 50b = $900b(b) Calculate M2 for Econometallica.ANS: M2 = M1 + Savings type accounts + MMMF + Small Time Deposits = 900b +2000b + 1000b + 500b = $4400b(c) Using the definition of the money supply in chapter 11 of Hall and Lieberman, whatis the money supply for Econometallica?ANS: Money Supply = Cash in hands of public + Demand Deposits = 300b + 400b =$700b(d) Which item is not included in the calculations of M1 and M2?ANS: Large Time Deposits2. Suppose Moey deposits $100,000 in Bank 1 and Ming borrows $80,000 from Bank 1to buy a Dodge Viper. The required reserve ratio for all banks (set by the Fed) is 20%.Dodge deposits the money from Ming’s Viper purchase in Bank 2. Assume that thereare no currency drains.(a) Fill in the following balance sheets, for Bank 1 and Bank 2, respectively:Bank 1 ‘s Balance SheetAssets LiabilitiesReserves: $20,000 Demand Deposits: $100,000Loans: $80,000Bank 2’s Balance SheetAssets LiabilitiesReserves: $80,000 Demand Deposits: $80,000Loans: $0(b) What is the level of required reserves Bank 1 must hold after Moey’s deposit?ANS: RR = $100,000 x 0.2 = $20,000(c) What is the level of required reserves Bank 2 must hold after Dodge’s deposit?ANS: RR = $80,000 x 0.2 = $16,000(d) Are these two Required Reserves the same? If so, why? If not, why not? ANS: They’re not the same since only part of Moey’s demand deposits (namely the partthat exceeds the RR) is lent out. Hence only part of the initial deposit of $100,000 goesinto Bank 2’s balance sheet (and remember that balance sheets always balances!).3. This question will test your understanding of the DD multiplier (or moneymultiplier).Suppose the Fed buys $5000 bonds from Bob. In return for the Bonds it gives Bob acheck for $5000. Suppose Bob banks with Bank A, and the RR ratio for all banks is20%. Assume there are no currency drains in this question and that banks do not holdexcess reserves. Answer the following questions.(a) What will be the change in DD on the balance sheet of Bank A?ANS: Since Bob deposits all $5000, the DD in Bank A increase by $5000.(b) What is the total change in required reserves and excess reserves on the balancesheet of Bank A?ANS: Since Total Reserves = RR + ER, and this balances with the liabilities of the bank(i.e., the increase in DD), it will be $5000 also.(c) Suppose Bank A lends out all their ER to George. What will be the amount of theloan (Hint: Q2 multiple choice might help?) ANS: In this case the RR ratio = $5000 x 0.2 = $1000, and hence ER = $5000 - $1000 =$4000. The loan will be $4000.(d) Suppose that George deposits the loan in Bank B, and Bank B again loans out all itsER from George’s deposit to Pete. Again, what will be the amount of the loan? Whatwill be the change in DD on the balance sheet of Bank B?ANS: DD will increase by $4000, while RR = $4000 x 0.2 = $800, ER = $4000 - $800= $3200 = amount of loan.(e) If this process repeats itself again and again (i.e. Pete deposits all his money in BankC and Bank C loans out all
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