First Terrier Bank. Reserves 2,800 Checkable Deposits 20,000. Total Assets 20,000 Total Liabilities 20,000

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1 Eco 202 Name Test 2 30 March 2007 Please write answers in ink. You may use a pencil to draw your graphs. Allocate your time efficiently. Good luck and don t enjoy your spring break too much. 1. a. Draw a simple T-account for First Terrier Bank (FTB), which has $20,000 of deposits, a required reserve ratio of 10 percent, and excess reserves of $800. Make sure you balance sheet balances. First Terrier Bank Assets Liabilities Reserves 2,800 Checkable Deposits 20,000 Treasury Bills 4,200 Loans 13,000 Total Assets 20,000 Total Liabilities 20,000 b. Assume that all other banks hold only the required amount of reserves. If First Terrier decides to reduce its reserves to only the required amount, by how much can it increase lending? $800 c. As a result of this loan, what is the potential increase in the quantity of money? D = 1/r * R D = 10 * $800 = $8,000. d. Now assume that the Fed purchases a $2,000 Treasury Bill from FTB? What happens to First Terrier s level of excess reserves? It increases by $2,000, which means it can increase its lending by $2,000 e. How much can First Terrier lend after the Fed s purchase? What is the potential increase in the quantity of money as a result of the Fed s purchase? D = 1/r * R D = 10 * $2,000 = $20,000.

2 2. During the early 1930s there were a number of bank failures in the United States. What did this do to the money supply? The New York Federal Reserve Bank advocated open market purchases. Would these purchases have reversed the change in the money supply and helped banks? Explain. Bank failures cause people to lose confidence in the banking system so that deposits fall and banks have less to lend. Further, under these circumstances banks are probably more cautious about lending. Both of these reactions would tend to decrease the money supply. Open market purchases increase bank reserves and so would have at least made the decrease smaller. The increase in reserves would also have provided banks with greater liquidity to meet the demands of customers who wanted to make withdrawals. In short, while the actions of depositors and banks lowered the money supply, the Fed could have increased it by buying bonds. 3. In the space below, please illustrate using the market for reserves (federal funds) the effect on the federal funds interest rate of an open market sale of government bonds by the Fed. Be sure to label correctly: the axes, the demand and supply schedules, the original interest rate and level of reserves, and the new interest rate and level of reserves.

3 3. b. When would the Fed take this policy action? Explain. The Fed will take such a policy action to raise the federal funds interest rate and drain reserves from the banking system. This action will have the effect of dampening bank lending, and raising the interest rates that businesses and consumers pay to borrow loanable funds. This will slow spending growth, which, in turn, will check the upward pressure on prices. In short, the Fed will take this action to keep inflation in check. 4. In recent years Venezuela and Russia have had much higher nominal interest rates than the United States while Japan has had lower nominal interest rates. What would you predict is true about money growth in these other countries? Why? The Fisher effect says that increases in the inflation rate lead to one-to-one increases in nominal interest rates. The quantity theory says that in the long run, inflation increases one-to-one with money supply growth. It follows that differences in nominal interest rates may be due to differences in money supply growth rates. It is reasonable to guess that much higher nominal interest rates in Venezuela and Russia indicate higher money supply growth while lower interest rates in Japan indicate lower money supply growth.

4 Eco 202 Name Test 2 30 March 2007 Please write answers in ink. You may use a pencil to draw your graphs. Allocate your time efficiently. Good luck and don t enjoy your spring break too much. 1. a. Draw a simple T-account for First Terrier Bank (FTB), which has $10,000 of deposits, a required reserve ratio of 10 percent, and excess reserves of $300. Make sure you balance sheet balances. First Terrier Bank Assets Liabilities Reserves 1,300 Checkable Deposits 10,000 Treasury Bills 2,700 Loans 6,000 Total Assets 10,000 Total Liabilities 10,000 b. Assume that all other banks hold only the required amount of reserves. If First Terrier decides to reduce its reserves to only the required amount, by how much can it increase lending? $300 c. As a result of this loan, what is the potential increase in the quantity of money? D = 1/r * R D = 10 * $300 = $3,000. d. Now assume that the Fed purchases a $1,000 Treasury Bill from FTB? What happens to First Terrier s level of excess reserves? It increases by $1,000, which means it can increase its lending by $1,000 e. How much can First Terrier lend after the Fed s purchase? What is the potential increase in the quantity of money as a result of the Fed s purchase? D = 1/r * R D = 10 * $1,000 = $10,000.

5 2. Explain how each of the following changes the federal funds interest rate. a. The Fed buys bonds The supply of reserves will shift to the right, lowering the federal funds interest rate. b. The Fed raises the discount rate Banks will borrow less, causing the supply of reserves to fall (leftward shift) raising the federal funds interest rate. c. The Fed raises the reserve requirement The demand for reserves will shift to the right, raising the federal funds interest rate. d. In the space below, please illustrate using the market for reserves (federal funds) the effect on the federal funds interest rate of an open market purchase of government bonds by the Fed. Be sure to label correctly: the axes, the demand and supply schedules, the original interest rate and level of reserves, and the new interest rate and level of reserves. An open market purchase of government securities adds reserves to the banking system. The increased quantity of reserves is shown as a rightward shift in the supply of reserves in the market for federal funds. The increase in the available quantity of reserves means an excess supply of reserves at the original federal funds interest rate. This excess supply will put downward pressure on the federal funds rate, causing it to fall until the new equilibrium is reached at i 2.

6 3. During the early 1930s there were a number of bank failures in the United States. What did this do to the money supply? The New York Federal Reserve Bank advocated open market purchases. Would these purchases have reversed the change in the money supply and helped banks? Explain. Bank failures cause people to lose confidence in the banking system so that deposits fall and banks have less to lend. Further, under these circumstances banks are probably more cautious about lending. Both of these reactions would tend to decrease the money supply. Open market purchases increase bank reserves and so would have at least made the decrease smaller. The increase in reserves would also have provided banks with greater liquidity to meet the demands of customers who wanted to make withdrawals. In short, while the actions of depositors and banks lowered the money supply, the Fed could have increased it by buying bonds. 4. a. Suppose the Fed sells government bonds. Use a graph of the money market to show what this does to the value of money and to the price level. Be sure to label correctly: the axes, the demand and supply schedules, the original and new quantity of money, price levels, and value of money.

7 4. b. When would the Fed take this policy action? Explain. The Fed will take such a policy action to drain reserves from the banking system so as to reduce the quantity of money (or slow its growth). A decline in the quantity of money raises the value of money and lowers the price level.