chapter: Solution Money, Banking, and the Federal Reserve System

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1 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? a. You sell a few shares of stock and put the proceeds into your savings account. b. You sell a few shares of stock and put the proceeds into your checking account. c. You transfer money from your savings account to your checking account. d. You discover $0.25 under the floor mat in your car and deposit it in your checking account. e. You discover $0.25 under the floor mat in your car and deposit it in your savings account. 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 your savings account increases M2, since savings accounts are part of M2 (but not part of M1). M1 does not change. b. Shares of stock are not a component of either M1 or M2, and so holding fewer shares does not decrease either M1 or M2. However, depositing the money into your checking account increases M1, since checking accounts are part of M1. It also increases M2, since M1 is part of M2. c. Moving money from savings to checking has no effect on M2, since both savings accounts and checking accounts are included in M2. However, since savings accounts are not part of M1, moving money from savings to checking does increase M1. d. Depositing cash into a checking account does not change M1 or M2. You are simply transferring money from one component of M1 (currency in circulation) to another component of M1 (checkable deposits). e. Depositing $0.25 into your savings account has no effect on M2, since both savings accounts and currency in circulation are in M2. However, since savings accounts are not part of M1, depositing the $0.25 into your savings account reduces M1. 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? a. Bottles of rum were used to pay for goods in colonial Australia. b. Salt was used in many European countries as a medium of exchange. c. For a brief time, Germany used paper money (the Rye Mark ) that could be redeemed for a certain amount of rye, a type of grain. d. The town of Ithaca, New York, prints its own currency, the Ithaca HOURS, which can be used to purchase local goods and services. chapter: ECONOMICS MACROECONOMICS S-193 KrugWellsECPS3e_Macro_CH14.indd S-193

2 S-194 MACROECONOMICS, CHAPTER 14 ECONOMICS, CHAPTER a. A bottle of rum is commodity money since the rum has other uses. b. Salt is commodity money since it has other uses. c. The Rye Mark is commodity- backed money since its ultimate value is guaranteed by a promise that it can be converted into valuable goods (rye grain). d. Ithaca HOURS are fiat money because their value derives entirely from their status as a means of payment in Ithaca. 3. The table below shows the components of M1 and M2 in billions of dollars for the month of December in the years 2000 to 2010 as published in the 2011 Economic Report of the President. Complete the table by calculating M1, M2, currency in circulation as a percentage of M1, and currency in circulation as a percentage 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? Currency Currency in in circulation circulation Currency Money as a as a in Traveler s Checkable Savings Time market percentage percentage Year circulation checks deposits deposits deposits funds M1 M2 of M1 of M $531.2 $8.3 $547.4 $1,878.0 $1,046.0 $902.0???? , ???? , ???? , ???? , ???? , ???? , , ???? , , ???? , , ,080.5???? , , ???? , ???? Source: 2011 Economic Report of the President. 3. In the completed table that follows, M1 consists of currency in circulation, traveler s checks, and checkable deposits. M2 consists of M1 plus money market funds, time deposits, and savings deposits. From 2000 to 2010, M1 nearly doubled, and the same was true of M2, which also almost doubled from 2000 to Currency as a percentage of M1 was relatively stable, at around 50%, with a rise during the econmic boom years until 2007 and subsequent fall. Currency as a percentage of M2 was almost constant at between 10% and 11%. The increase in currency as a percentage of M1 during the mid-2000s could reflect increased use of credit cards, with a corresponding reduction in the importance of traveler s checks and checkable deposits. Yet, since currency as a percentage of M2 did not change, it could also reflect a shift from checkable deposits to money market funds, time deposits, and savings deposits. KrugWellsECPS3e_Macro_CH14.indd S-194

3 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-195 Currency Currency in in circulation circulation Currency Money as a as a in Traveler s Checkable Savings Time market percentage percentage Year circulation checks deposits deposits deposits funds M1 M2 of M1 of M $531.2 $8.3 $547.7 $1,878.0 $1,046.0 $902.0 $1,087.2 $4, % 11% , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Source: 2011 Economic Report of the President. 4. Indicate whether each of the following is part of M1, M2, or neither: a. $95 on your campus meal card b. $0.55 in the change cup of your car c. $1,663 in your savings account d. $459 in your checking account e. 100 shares of stock worth $4,000 f. A $1,000 line of credit on your Sears credit 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. c. $1,663 in your savings account isn t directly usable as a medium of exchange, so it is not part of M1; but because it can readily be converted into cash or checkable deposits, it is part of M2. d. A $459 balance in your checking account is part of both M1 and M2; it represents a checkable deposit. e. 100 shares of stock are not part of either M1 or M2. Although an asset, stock is not a highly liquid asset. f. A $1,000 line of credit on your Sears credit card is not part of either M1 or M2 because it does not represent an asset. 5. Tracy Williams deposits $500 that was in her sock drawer into a checking account at the local bank. 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? KrugWellsECPS3e_Macro_CH14.indd S-195

4 S-196 MACROECONOMICS, CHAPTER 14 ECONOMICS, CHAPTER 29 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? d. 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 and the bank maintains a reserve ratio of 5%, by how much could the money supply expand in response to Tracy s initial cash deposit of $500? 5. a. Initially, the bank s reserves rise by $500, as do its checkable deposits. There is no initial change in the money supply; currency in circulation has fallen by $500 but checkable deposits have increased by $500. Reserves +$500 Checkable Deposits +$500 b. The bank will hold $50 as reserves against the new deposit and make additional loans equal to $450. c. The money supply can expand by $4,500. When Tracy deposits $500, the bank now holds $450 in excess reserves. This will ultimately lead to an increase in the money supply of $450/0.1 = $4,500. d. The money supply can expand by $9,500. When Tracy deposts $500, the bank now holds $475 in excess reserves. This will ultimately increase the money supply by $475/0.05 = $9, 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 withdrawal? 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? d. If every time the bank decreases its loans, checkable bank deposits fall by the amount of the loan and the bank maintains a reserve ratio of 20%, by how much will the money supply contract in response to a 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. Reserves $400 Checkable Deposits $400 KrugWellsECPS3e_Macro_CH14.indd S-196

5 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-197 b. Assuming that the bank has other checkable deposits, the bank will be holding insufficient reserves. The bank was holding $40 of the $400 withdrawal as required reserves for the $400 deposit; however, the remaining $360 was being held as required reserves for other deposits. The bank will have to reduce its deposits by $360/0.1 = $3,600 to reduce its required reserves by $360 (10% of $3,600) in order to maintain the required reserve ratio of 10%. 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 converted 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 Currency held by public = $150 million Currency in bank vaults = $100 million Checkable bank deposits = $500 million Traveler s checks = $10 million a. What is M1? b. What is the monetary base? c. Are the commercial banks holding excess reserves? d. Can the commercial banks increase checkable bank deposits? If yes, by how much can checkable bank deposits increase? 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. c. Required reserves are $50 million (10% of $500 million). Because total reserves are $300 million [currency in bank vaults ($100 million) plus bank deposits at the central bank ($200 million)], the commercial banks are holding $250 million ($300 million $50 million) in excess reserves. d. Since the commercial banks are holding excess reserves, they can increase deposits. With a required reserve ratio of 10%, reserves of $300 million can support a total of $300 million/0.1 = $3,000 million in deposits. Commercial banks can increase deposits by an additional $2,500 million. KrugWellsECPS3e_Macro_CH14.indd S-197

6 S-198 MACROECONOMICS, CHAPTER 14 ECONOMICS, CHAPTER 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 accompanying table. (Hint: The first row shows that the bank must hold $100 in minimum reserves 20% of the $500 deposit against this deposit, leaving $400 in excess reserves that can be loaned out. However, since the public wants to hold 50% of the loan in currency, only $ = $200 of the loan will be deposited in round 2 from the loan granted in round 1.) How does your answer compare to an economy in which the total amount of the loan is deposited in the banking system and the public doesn t hold any of the loan in currency? What does this imply about the relationship between the public s desire for holding currency and the money multiplier? Required Excess Held as Round Deposits reserves reserves Loans currency 1 $ $ $ $ $ ???? 3????? 4????? 5????? 6????? 7????? 8????? 9????? 10????? Total after 10 rounds????? 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 $ it initially fell by $500 and eventually rose again by $ ) If the total amount of each loan is deposited in the banking system (that is, the public does not hold any of the loans in currency), the money supply would increase by ($500/0.2) $500 = $2,000; deposits would increase by $2,500. The money multiplier decreases in size as the public holds a greater percentage of loans in currency. Required Excess Held as Round Deposits reserves reserves Loans currency 1 $ $ $ $ $ Total after 10 rounds $ $ $ $ $ KrugWellsECPS3e_Macro_CH14.indd S-198

7 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S What will happen to the money supply under the following circumstances in a checkable-deposits-only system? a. The required reserve ratio is 25%, and a depositor withdraws $700 from his checkable bank deposit. b. The required reserve ratio is 5%, and a depositor withdraws $700 from his checkable bank deposit. c. The required reserve ratio is 20%, and a customer deposits $750 to her checkable bank deposit. d. The required reserve ratio is 10%, and a customer deposits $600 to her checkable bank deposit. 9. a. Checkable deposits contract by $2,800, but $700 is converted into currency held by the public. The money supply contracts by $2,100. b. Checkable deposits contract by $14,000, but $700 is converted into currency held by the public. The money supply contracts by $13,300. c. Checkable deposits expand by $3,750, but currency in circulation falls by $750. The money supply expands by $3,000. d. Checkable deposits expand by $6,000, but currency in circulation falls by $600. The money supply expands by $5, 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 checkable deposits in the banking system. a. How will the money supply change if the required reserve ratio falls to 5%? b. How will the money supply change if the required reserve ratio rises to 25%? 10. a. If the required reserve ratio falls to 5%, the commercial banks of Albernia will be holding $50 million in excess reserves. Since the banks follow a policy of holding no excess reserves, the banks will expand deposits by making loans. The banks reserves of $100 million will support $2,000 million in deposits at a reserve ratio of 5%. The bank will expand loans and deposits by $1,000 million, so the money supply expands by $1,000 million. b. If the required reserve ratio rises to 25%, the commercial banks of Albernia will not be holding enough reserves to support $1,000 million in deposits. The banks reserves will only support $400 million in deposits. The commercial banks will have to decrease loans and deposits by $600 million, so the money supply will contract by $600 million. 11. Using Figure 14-6, find the Federal Reserve district in which you live. Go to and click on your district to identify the president of the Federal Reserve Bank in your district. Go to reserve.gov/fomc/ and determine if the president of the regional Federal Reserve bank in your district is currently a voting member of the Federal Open Market Committee (FOMC). KrugWellsECPS3e_Macro_CH14.indd S-199

8 S-200 MACROECONOMICS, CHAPTER 14 ECONOMICS, CHAPTER Answers will vary depending on where you live and when you look up your answer. For example, if you lived in Reedley, California, in September 2011, you were in the San Francisco district of the Federal Reserve system. John C. Williams was the president of the Federal Reserve Bank of San Francisco and an alternate (non voting) member of the FOMC at that time. 12. Show the changes to the T-accounts for the Federal Reserve and for commercial 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 deposits in the commercial banks change? By how much will the money supply change? Show the final changes to the T-account for commercial banks when the money supply changes by this amount. 12. 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 perspective of commercial banks, their assets fall by $50 million because they sell Treasury bills to the Fed, but their assets also rise by $50 million when their deposits at the Fed (reserves) are credited with $50 million. Initial changes to the T-account of the Federal Reserve immediately after the Fed purchase of $50 million in Treasury bills: Treasury bills +$50 million Monetary base +$50 million Initial changes to the T-account of commercial banks immediately after the Fed purchase of $50 million in Treasury bills: Treasury bills $50 million No change 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 any excess reserves, they will increase loans and deposits by $500 million, the maximum amount that $50 million in reserves can support. Therefore, the money supply will also increase by $500 million. Total changes to the T-account of commercial banks after the Fed purchase of $50 million in Treasury bills: Treasury bills $50 million Checkable deposits +$500 million Reserves +$50 million Loans +$500 million 13. 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 amount of checkable bank deposits in the banking system) and the minimum reserve ratio is 5%, by how much will checkable bank deposits in the commercial banks change? By how much will the money supply change? Show the final changes to the T-account for the commercial banks when the money supply changes by this amount. KrugWellsECPS3e_Macro_CH14.indd S-200

9 13. 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 the monetary base). From the perspective of commercial banks, their assets rise by $30 million because they buy the Treasury bills from the Fed, but their assets also fall by $30 million when they pay for the Treasury bills from their deposits at the Fed (their reserves). Initial changes to the T-account of the Federal Reserve immediately after the Fed sale of $30 million in Treasury bills: Treasury bills $30 million Monetary base $30 million MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S-201 Initial changes to the T-account of commercial banks immediately after the Fed sale of $30 million in Treasury bills: Treasury bills +$30 million No change Reserves $30 million After the Federal Reserve sells $30 million in Treasury bills, the banks are no longer holding enough reserves to support their deposits. The banks will need to reduce loans and deposits by $600 million the amount of deposits that were supported by the $30 million in reserves used to buy the Treasury bills. So the money supply will also decrease by $600 million. All changes to the T-account of commercial banks after the Fed sale of $30 million in Treasury bills: Treasury bills +$30 million Checkable deposits $600 million Reserves $30 million Loans $600 million 14. 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? b. As of August 2011, the interest rate earned on one-year U.S. Treasury bills was 0.11%. At a 0.11% rate of interest, what is the amount of money U.S. taxpayers are losing per year because of these $45 million in counterfeit notes? 14. 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 Treasury bills it would have gotten if it had printed the notes. The cost of counterfeiting is the interest forgone on U.S. Treasury bills that the U.S. government would receive from legally printed $100 notes. U.S. taxpayers lose because the government does not get this interest. b. The amount of interest forgone per year is 0.11% $45 million = $49,500. KrugWellsECPS3e_Macro_CH14.indd S-201

10 S-202 MACROECONOMICS, CHAPTER 14 ECONOMICS, CHAPTER As shown in Figure 14-9, the portion of the Federal Reserve s assets made up of U.S. Treasury bills has declined since Go to Under Select Statistical Releases, click on All Statistical Releases. Under the heading Money Stock and Reserve Balances, click on Factors Affecting Reserve Balances. Click on the date of the current release. a. Under Statement of Condition of Each Federal Reserve Bank, look in the Total column. What is the amount displayed next to Total assets? What is the amount displayed next to U.S. Treasury securities? What percentage of the Federal Reserve s total assets are currently made up of U.S. Treasury bills? b. Do the Federal Reserve s assets consist primarily of U.S. Treasury securities, as they did in January 2007, the beginning of the graph in Figure 14-9, or does the Fed still own a large number of other assets, as it did in mid-2011, the end of the graph in Figure 14-9? 15. a. Answers will vary. As of data released on October 5, 2011, the Fed s assets were $2,862,954 million, and U.S. Treasury holdings were $1,671,784 million; ($1,671,784/$2,862,954) 100 = 58.4% of the Fed s total assets were made up of U.S. Treasury securities. b. As of October 5, 2011, the Federal Reserve still owned a large number of other assets, and the Fed s balance sheet had not yet returned to normal. 16. The accompanying figure shows new U.S. housing starts, in thousands of units per month, between January 1980 and August The graph shows a large drop in new housing starts in and New housing starts are related to the availability of mortgages. New housing starts (thousands) 2,500 2,000 1,500 1, Source: Federal Reserve Bank of St. Louis. Year a. What caused the drop in new housing starts in ? b. What caused the drop in new housing starts in ? c. How could better regulation of financial institutions have prevented these two instances? KrugWellsECPS3e_Macro_CH14.indd S-202

11 MONEY, BANKING, AND THE FEDERAL RESERVE SYSTEM S a. The drop in new housing starts in was caused by the unavailability of easy mortgage financing resulting from the Savings and Loans (S&L) crisis. S&Ls had invested in overly risky real estate assets, and many of them failed. As the government closed over 1,000 S&Ls, mortgages became less easily available, and new housing starts dropped dramatically. b. The drop in new housing starts in was caused by the unavailability of easy mortgage financing that precipitated the 2008 financial crisis. When many homeowners who had financed their homes at subprime lending rates defaulted on their mortgages, those financial institutions that had invested in securitized subprime loans got into financial trouble and restricted or stopped lending. c. Better regulation of the S&Ls could have prevented them from investing in risky real estate assets, preventing their collapse. Similarly, better regulation of financial institutions that purchased securitized subprime loans could have prevented those institutions from failing. KrugWellsECPS3e_Macro_CH14.indd S-203

12 KrugWellsECPS3e_Macro_CH14.indd S-204